The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.

~F. Scott Fitzgerald

Update: Thanks to Arjun at Investing Thesis for including this article in the Canadian Personal Finance and Investing Carnival #16.

Very few topics elicit the kind of virulent debate that the TFSA vs. RRSP argument has generated in Canada this RRSP season. To be honest, those of us who cover finance are probably a little tired of writing about the TFSA vs. RRSP war. I’m sure a lot of readers don’t care to read about it anymore. And yet we (including me, apparently) just can’t seem to let it go. (The RRSP deadline for the 2010 tax year is March 1, 2011, so it should be over soon. )

For years, the RRSP was the stalwart, and really only, widely available tax deferral tool for the average Canadian. Rarely did it come under any real criticism in the mainstream media – until the TFSA came along. Now we see articles almost daily comparing the two. If you point out the short-comings of RRSPs, you can expect a rebuttal accusing you of being an RRSP basher or of “railing against” RRSPs as if you had lost control of your senses. Others will just come right out and say that you’re stupid. Now that really advances the conversation.

On the other side, those who staunchly defend the virtues of RRSPs are sometimes accused of being old-fashioned or in the pocket of the financial industry. Really? Some citizen blogger who works in a completely unrelated industry is conspiring with the Bay Street elite? As a Mom, this is the point at which I would step in between my sons and say “Come now boys. Let’s put this in perspective.”

How about a Little Perspective?

Let’s face it. Those of us who are knee-deep in the nitty-gritty of these financial issues can get a little carried away arguing over the details. To most people, it’s pretty obvious that both RRSPs and TFSAs are great savings and tax management tools for Canadians. Perhaps Jim Yih put it best in his recent article: TFSA or RRSP: Why Not Do Both?

The average Canadian is probably not interested in who’s right or wrong on the most minute details of either product. They just want to understand how they work and how they apply to their personal financial picture. There are some really good basic comparisons out there. Young and Thrifty recently posted a very comprehensive head to head comparison of the two. I wrote a TFSA vs. RRSP comparison last year too. If you’re interested in a little more detail, Larry MacDonald pointed out a few pitfalls to watch out for in 13 RRSP Blunders.

It can also be helpful to read about how other Canadians are choosing to allocate their savings. Paul Brent recently asked me how my family was handling the TFSA vs. RRSP quandary for a Globe and Mail article asking Why Choose a TFSA over an RRSP? The point of the article was simply to give some examples of scenarios where you might choose to top up your TFSA before, or instead of your RRSP.

When you couple the brief quotation in that article with an article I wrote more recently on 5 Reasons to Skip the RRSP Contribution this Year, it’s easy to see how some might put me in the RRSP-basher camp. To be clear, no one has done that to my knowledge. Still, I thought it might be helpful if I spelled my our current thinking on TFSAs vs. RRSPs vs. paying down debt.

Our RRSP Strategy

One area where I do sympathize with the RRSP critics is that I think we need to make sure to remember that we will pay a withdrawal tax when we initially draw down our RRSP accounts, and that the amount of tax we ultimately pay on those withdrawals won’t be finalized until we file our taxes for the year of the withdrawal. It’s important to realize that anything you take out of an RRSP is treated as ordinary income, whether it came from your deposits, capital gains, dividends, or interest income.

On the other hand, TFSAs don’t provide the up-front tax deduction that RRSPs offer. In 2009, we happened to receive a one-time deferred compensation payment from a former employer that would have boosted our income beyond the highest tax bracket. We put some of that money toward our mortgage balance and the remainder in an RRSP. We were able to simultaneously pay down debt, reduce our tax burden, and shore up our retirement savings. This is a good example of an instance where the RRSP makes a lot more sense.

We also maxed out our TFSAs in 2009, the first year they were offered. During the period from 2008 to 2010, our income was uncertain as my husband changed jobs a few times. The money in the TFSA provided a cushion in case of further volatility in our income.

We put a little more money into our TFSA in 2010, but nothing in our RRSP. Our income wasn’t as high, and we chose to put almost all of our disposable income into paying down the mortgage. In 2011, we will pay down the mortgage first, since we don’t have much left owing on it. Next, we will need to contribute to our sons’ RESPs. Two of them will turn 16 this year, so next year is the last year we can contribute for them and still receive the 20% CESG kick.

Larry MacDonald’s article made a good point about the perils of paying down your mortgage at the expense of saving for retirement. We felt OK pursuing this strategy now because we already have a decent emergency fund saved as well as a good start on retirement savings. If we had nothing saved for retirement, we probably wouldn’t be as aggressive about paying down our last remaining debt.

For me, the hardest part of deciding whether (or how much) to contribute to an RRSP in a given year is trying to guess what the future might hold. How will our current marginal tax rate compare to the one we’ll pay in retirement? If our income hits the upper tax brackets in a given year, we will certainly take advantage of the RRSP tax deduction. In addition, Mr. Cents will be eligible for the company RRSP plan this year, so we’ll take advantage of their offer to match monthly contributions up to a certain level as well.

The Bottom Line

TFSAs are better than RRSPs for some Canadians in some years. RRSPs are the better choice for some Canadians in some years. For the majority of Canadians in most years, a little of each is probably a good idea. Declaring a winner is so much less important than understanding how both vehicles work and more importantly, how best to apply them to your own circumstances each year.

How are you handling your savings this year?

(Photo Credit: Feng Yu)