Should you invest an inheritance in an RRSP or a TFSA?

An example may help put this concept into context. Say, you had $10,000 to contribute to either a TFSA or an RRSP. If you contribute the full amount to a TFSA, and it grows at 5% per year, it would be worth $16,289 after 10 years. You could withdraw it, pay no tax and spend that $16,289.

By comparison, if you contribute that $10,000 to an RRSP and you’re in a 30% tax bracket, you get your investment plus a $3,000 tax refund, which means you come out ahead initially. If we assume you contribute that $3,000 to a TFSA, and it grows at 5% per year for 10 years, you would have $16,289 in the RRSP and $4,887 in a TFSA a decade later.

At first, the RRSP seems like a better outcome. However, if you are also in a 30% tax bracket when taking the RRSP withdrawal, you would only have $11,402 after tax. Combined with a withdrawal of the $4,887 tax-free from the TFSA, you have the same $16,289 to spend as if you had contributed the whole $10,000 to the TFSA in the first place.

Project your income in retirement

Most people end up in a lower tax bracket once they retire, but not everyone does, Kate. People with a low income prior to retiring may be more likely to remain in the same bracket.

So, for your situation, it may be that your spouse should contribute to their RRSP, but you should not contribute to yours, for example. You must try to project your future income, while also taking into account other retirement income sources, like Canada Pension Plan (CPP) and Old Age Security (OAS).

If one of you dies at an early age, the survivor may be in a higher tax bracket with all income taxed on one tax return. And if your future incomes are approaching the OAS clawback limit—$90,997 in 2024 for OAS recipients—that can push up your effective tax rate on RRSP withdrawals up by 15%.

An OAS recipient can be paying more than 55% marginal tax in retirement (or over 62% tax in Quebec). This is higher than a working age taxpayer earning millions.

Contribute to registered accounts with caution

So, the moral of the story, Kate, is to contribute with caution. The spousal RRSP idea might be a good one for your higher-income spouse. If they have a lot of RRSP room, consider deducting the contribution over a couple of years.