(Originally posted October 27, 2008)

The short answer is that there is no short answer. This is question that American investors had to struggle with for a while, and fortunately Canadians will have to grapple with starting next January when TSFAs become available here.

Basically there are two broad categories of investment vehicles: tax-free (or more accurately, using after-tax dollar but allow tax-free accumulation with no taxes payable on withdrawal) and tax-deferred (investing pre-tax dollars, with taxes to be paid in full when funds are withdrawn).

If I understand it correctly, in the U.S. an individual (under 50) can contribute to either or both the tax-deferred 401(k) ($15,500 max) or tax-free Roth 401(k) ($5,000 max) for a grand total of $15,500. Together with the employer’s contribution the 401(k) annual max is $46,000. Also, there are income restrictions on the Roth plans, such as $99,000 for individuals and $156,000 for families, and there are some additional contributions permitted for over 50 investors.

For Canadians the new tax-free TFSA vehicle maximum is $5,000 annually per individual starting in 2009 and the tax-deferred RRSP is 18% up to $20,000 for 2008 (subject to the PA-pension adjustment if you are member of a pension plan, even if your plan sponsor has significantly underfunded your plan and there is a significant probability that at least a portion of your pension is in jeopardy). What’s nice here is that, if I understand it correctly, you are permitted to invest in each without affecting the maximum of the other.

The short answer to TFSA or RRSP, if there was one, is that it depends on your marginal tax rate differential between the tax rate when you are making the investment, Tax.In (during your working/saving years) and the Tax.Out rate expected in retirement.

If Tax.In < Tax.Out then invest in TFSA (Canada) Roth 401(k) (U.S.)

If Tax.In > Tax.Out then invest in RRSP (Canada) and 401(k) (U.S.)

Or, the simple way to remember is that you would prefer to pay the tax when it is at a lower rate. This is because independent of the return (assuming same return in all accounts) that you get over the life of the investment, the ratio of the values of TFSA/RRSP or Roth401 (k)/401(k) or (Tax-Free Account)/(Tax-deferred Account) that you get after tax  for each $1 pre-tax invested is

Mathematically the ratio in the above table is:  (Tax-Free Account)/(Tax-deferred Account)= (1-Tax.In)/(1-Tax.Out)  (see Appendix below for explanation if you are analytically inclined )

Notice from the table, for example, if Tax.In = Tax.Out then the ratio is equal to 1 (i.e. then your after tax return is the same in either type of account). If however Tax.In =40% and Tax.Out =25% then the ratio is 0.73, i.e. you are better off investing in a tax-deferred account (RRSP, 401(k)). If however, Tax.In= 25% and Tax.Out= 40% then the ratio is 1.25% so it is better to invest into a tax-free account (TFSA, Roth 401(k)).

But the simple answer is not the complete answer since it depends on the expected (unknown) marginal tax rate during retirement. Generally speaking you’d expect to have lower income in retirement and therefore lower marginal tax rate. However the future is unpredictable. Here are a few factors mentioned by Reichenstein and Trainor in Choice of Savings Vehicles When Saving in Retirement from CFA Institute’s Private Wealth Management Quarterly:

-there are minimum distribution requirements from the tax-deferred accounts

-draws from tax-deferred account on top of government and private pensions can put you in a higher tax bracket and  potentially affect some government benefits (e.g. OAS claw-backs)

-current contributions to tax-deferred account can reduce your current tax bracket

Other considerations are:

-are you expecting to work in retirement and thus more likely to be in a high(er) tax bracket then

-will your income be increasing rapidly during your working years and do you expect to accumulate significant assets (e.g. young professional)- using tax-free account initially may be advantageous

Conclusion

The greatest imponderable may in fact be what the future tax rates in your retirement (tax rates and tax brackets). Given this unknown it may make sense to go for “tax diversification’” to split your  investments between tax-deferred and tax-free accounts, so that during retirement you will have the flexibility to select from where you draw your income depending on tax and other income considerations. Of course you should make sure to first contribute to your tax-deferred account at least enough to get your employer’s matching contribution (free money).

For Canadians, who will have the option to contribute to both RRSP and TFSA without having the contribution to one affect the contribution limit to the other, ideally if you can manage you should contribute the maximum allowable to both.

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Appendix (If you are analytically inclined)

For $1 invested at an overall end return of R over any   period you have $(1+R)

If you invest in a taxable or tax-free account the $1 you start with results in $(1-Tax.In) available to invest. Therefore, given that no tax is payable when you take the money out in retirement you’ll have (1+R)*(1-Tax.In)

If you are investing in a tax-deferred account then the full $1 is available for investment, but when you take the money out in retirement you get $(1+R) reduced by the tax payable (1+R)*(1-TaxOut)

Let’s use TSFA and RRSP as the generic names of tax-free and tax-deferred accounts, then we can calculate the ratio of the two possible outcomes as follows (and return cancels out, so long as you assume that returns are the same in both accounts, if you invest in the same assets):

TFSA= (1+R)*(1-TaxIn)

RRSP= (1+R)*(1-TaxOut)

TFSA/RRSP= (1-TaxIn)/(1-TaxOut)

Therefore

-if TaxIn > TaxOut then TFSA<RRSP then RRSP is better

-if TaxIn < TaxOut   then TFSA>RRSP then TFSA is better

And you can easily also prove what is intuitively obvious, that both TFSA and RRSP are better than a taxable account where the end value would be even further reduced by paying tax on the way in and then on the way out so the value of $1 would be (1-Tax.In)+ (1-Tax.In)*R*(1-Tax.Out), because the capital  gain portion is taxed (the second term).