Should I hold dividend and fixed income mutual funds in a TFSA or RRSP?

Should Eleanor invest her $20,000 in a TFSA or RRSP?

How to calculate where you should put your money to grow

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Q. I would like to invest $10,000 in an RBC mutual fund with a 4% dividend and another $10,000 in a fixed income Bond fund yielding 4%. Which account should I hold these in—my TFSA or RRSP—and does it really make a difference? Thanks, Eleanor H.

Eleanor, I need to be careful how I answer your question because there is no difference while invested, but there’s a difference when going into, and coming out of a TFSA or RRSP.

While invested; dividends, yields, capital gains, interest, it doesn’t matter, they all contribute to the growth inside the TFSA/RRSP and there are no tax consequences.

When deciding between a TFSA and an RRSP you want to consider your contribution approach, and your anticipated tax situation at the time of withdrawal.

If I am reading your question correctly, you’re really asking is there a difference between a TFSA and an RRSP and if there is, what is the difference?

You have $20,000 to invest, and I’ll assume that you have the room to contribute to either the RRSP or TFSA, and your marginal tax rate is 30%.

The table below shows the growth of a $20,000 contribution to both a TFSA and an RRSP.  I’ve rounded the numbers a little. You will notice that I grossed up the RRSP contribution to $28,571. This is the amount of money you had to earn to have $20,000 to contribute to a TFSA. Here is the formula: $20,000/(1-marginal tax rate —30%).

You will see that after 20 years of growth the after-tax value is the same; there is no difference between the RRSP and the TFSA. I assumed the same tax rate.

 

TFSA RRSP
After tax contribution $20,000 $20,000
Gross up contribution* $28,571
20 yrs, 5% growth $53,066 $75,807
Withdrawal tax rate 30% $0.00 $22,741
After tax value $53,066 $53,066

Now let’s see what would happen if you didn’t gross up your RRSP deposit and made a $20,000 contribution to both your TFSA and RRSP.  You’ll see in the table below that the after-tax value of the TFSA is much better than the RRSP.

TFSA RRSP
After tax contribution $20,000 $20,000
20 yrs, 5% growth $53,066 $53,066
Withdrawal tax rate 30% $0.00 $15,919
After tax value $53,066 $37,146

If you are not going to gross up your RRSP contribution then the TFSA is generally the way to go.  The exception being when you maximize your RRSP and then you would contribute the tax deduction into your TFSA.

Looking at the tables above you can see that if you make the same pre- and after-tax contributions to a TFSA and RRSP, there is no difference if your marginal tax rate stays the same. Let’s take a look and see what happens if your marginal tax rate is higher or lower when you withdraw the money:

 

Same contribution and withdrawal rate 30% Lower withdrawal rate 20% Higher withdrawal rate 40%
TFSA RRSP RRSP RRSP
After tax contribution $20,000 20,000 $20,000 $20,000
Gross up contribution* $28,571 $28,571 $28,571
20 yrs, 5% growth $53,066 $75,807 $75,807 $75,807
Withdrawal tax rate $0.00 $22,741 $15,161 $30,322
$53,066 $53,066 $60,645 $45,484

You can see in the table above that if your tax rate is lower than when you made the contribution, the RRSP is better than the TFSA.  Conversely, if your tax rate is higher, the TFSA would have been better.

In addition to considering your future marginal tax rate, you’ll also want to consider things like OAS clawback, GIS, the age credit, GST credits….

So yes Eleanor, it does make a difference as to which account you contribute to, but it’s due to your current and future marginal tax rate, not the dividend rate on the investments.

Allan Norman, M.Sc., CFP, CIM, Atlantis Financial/IPC Investment Corp

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