Buridan’s Mule: Personal finance edition

Editor's Note

This is article is sponsored by Richardson GMP Limited.

Buridan’s Mule is an illustration of the challenge that free choice poses. A mule is stationed at an equal distance from both a pail of water and stack of hay. Regrettably, the fable says that the mule will perish from the inability to make a choice at all.

You may have wondered “If I have a finite amount to invest and I have to choose between contributing to my TFSA or to my RRSP, which one do I choose?” It’s a question we are often asked and, as is frequently the case with financial questions, the answer is, “it depends.” The ambiguity of the answer sometimes leads people to choose neither and not invest the money in either tool. Don’t let your behavioural biases cause you to be a victim of this! It is important to take advantage of time, and to allow your investments to compound, so the sooner you make your RRSP or TFSA contributions, the better.

First, remember RRSP and TFSA contributions have different tax treatments.

  • An RRSP is primarily for retirement savings, a TFSA is for more general investment savings
  • RRSP contributions are tax deductible and reduce your taxable income, and therefore your tax bill. Let’s say you make $100,000 and you make a $10,000 RRSP contribution. You will report $100,000 as employment income and on your tax return you will be able to report that you made a $10,000 RRSP contribution and reduce the amount of income that is subject to tax by that $10,000 so that you will only pay tax on $90,000 when you contribute into the RRSP.
  • TFSA contributions, on the other hand, are not deductible. In the same scenario where you make $100,000, you will be taxed on the full $100,000 and will contribute to your TFSA from the after-tax money (or take home) cash you have available.
  • Withdrawals from your RRSP are added to your income while TFSA withdrawals are tax-free.
  • When it comes time for you to withdraw from your RRSP, let’s say you take out that $10,000 you had contributed when you were working. The $10,000 will be included in your income.
  • RRSPs must be converted to a RRIF by age 71 and, after which, there are required minimum withdrawals, using a formula based on your age.  So the money will be included in income and taxed eventually. There are no such requirements for TFSAs.
  • When it comes to RRSPs, once a contribution is made, that contribution room “expires,” such that if you make a withdrawal you cannot replace the funds. With TFSAs, the amount of a withdrawal, which can include growth, is added back to the contribution room in the following year.

So, if you are currently in a high income tax bracket and you don’t foresee needing the funds in the short term, then contributing to your RRSP may be the appropriate choice. Firstly, that $10,000 contribution will have a long time to grow in the RRSP and no taxes will have to be paid on the income while the monies are left in an RRSP account. When you withdraw the $10,000, then it will be included in your income. However, you will likely withdraw the money when you are no longer working and will not have employment or business income, so your income is likely to be lower and therefore your tax rate will be lower.

If you earn more modestly now but expect to have a large pension or other sources of income in retirement, contributing to your TFSA is likely the answer. If you are going to be roughly in the same tax bracket in the future, as you are today, then you should be indifferent.  

Most people will have a dollar figure in mind to contribute to their savings plan. As we noted earlier, the RRSP will generate a tax refund. Many will spend that refund rather than either contributing it back to the RRSP or grossing up the RRSP contribution to take into account the tax that will be imposed on the withdrawal in the future. In this way, the contribution to the TFSA is “worth” more in the long term, since it will not be taxed when it is withdrawn in the future.

On the other hand, people have the tendency to view RRSPs as more “sacred” or “untouchable” whereas there is a temptation to access TFSAs more readily. If you are looking to save for the long term, then contributing to your RRSP may make more sense because it has an effect on your behaviour. Just remember, gross-up the contribution for the taxes that will be due when you withdraw the money.

As you can see, there’s no definitive answer. As chartered accountants turned to investment advisors, we are here to help you make the decision most relevant to your circumstances and avoid the fate of Buridan’s mule.  

If you have more questions about RRSPs and TFSAs, you can reach me at Joelle.Hall@RichardsonGMP.com

This article is supplied by Joelle Hall of Hall O’Brien Wealth Counsel, an Investment Advisor with Richardson GMP. Richardson GMP Limited, Member Canadian Investor Protection Fund.

Hall O’Brien Wealth Counsel specializes in tax-efficient portfolios and planning. We speak your language so you feel confident in the plan we implement together.

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