RRSP vs TFSA - The Ongoing Debate
Hello All,
If you search for RRSPs vs TFSAs on the internet, there are about 3.6 million results (some of which I have linked to in the past). But, since the RRSP deadline is approaching and I have spent many hours contemplating and discussing the topic, I thought it might be an opportune time to have a brief discussion. Like most money topics, it isn’t necessarily super exciting , but a good decision can literally make you richer.
So, a TFSA (tax free savings account) is a savings account that you contribute to from after tax dollars (i.e. there is no tax deduction for contributions) but all of the investment income earned in the account is generated tax free in perpetuity (or until CRA decides to change something)
An RRSP (Registered Retirement Savings Plan) by contrast is also a savings account but you contribute to it with before tax dollars i.e. you receive a deduction against your net income up to an annual maximum amount. The investment income earned in an RRSP account is not tax free but rather tax deferred. This means that when you withdraw funds from your RRSP (usually when you retire), you pay tax on the amount withdrawn, at your tax rate, in the year of withdrawal.
Setting up either a TFSA or RRSP is simple: you determine your contribution room and go to a financial institution which can be one of the big 5 banks, a boutique bank, a brokerage, robo advisor etc and create an RRSP and/or TFSA account. You then decide what type of investments you would like to hold in the account eg. fixed income GICs, stocks, bonds, mutual funds etc. all of which have different levels of risk. Whatever allocation you choose can be changed over time so your investment choice is not carved in stone. It should be noted that the closer you are to retirement age, the less risk you should assume in your investment portfolio and as such shifting your allocation to less risky investments is something that should be done actively.
Of course everyone wants to know which is better. In a perfect world, you would contribute the maximum allowed to both every year. In an imperfect world, where many of us only have a limited amount of funds to contribute, the decision becomes more complex.
If you are young, don’t have significant earnings but expect your earnings to increase as you put in more years into your career or business, it makes sense to max out your TFSA and then use any leftover funds to contribute to your RRSP. The reason for this is that the tax deduction for the RRSP is based on the highest tax bracket that is applicable to you in any given year. Consequently, the higher your tax rate, the higher the deduction against income and corresponding reduction in taxes. This is not applicable to TFSAs since there is no deduction for contributions to TFSAs.
That being said, regardless of which vehicle you choose, the power of compounding with any type of investment is significant. As an example, $5,000 per year over 30 years i.e. a total investment of $150,000 invested at 5% (which is lower than the average return on the stock market) would result in $338,899.11 at the end of 30 years. ( You actually earn more than you invest!). In other words, the younger you are when you start investing the better this looks. (You can do your own calculations here to motivate you to start investing.)
It should also be noted that contributions for both TFSAs and RRSPs are cumulative. This means that if you invest less than the maximum allowable amount per year, the difference is added to the total you can contribute in future years. You can also withdraw from both the TFSA and RRSP. If you withdraw from your TFSA, you can recontribute the amount withdrawn at the beginning of the year following the withdrawal. With RRSPs, however, you simply lose the contribution room. Note that it is better to view RRSPs as a retirement fund that you should only withdraw in extenuating circumstances. TFSAs conversely can be viewed as a savings account or emergency fund that you can use when necessary.
So, while it depends on each individuals circumstances which includes age, income, tax brackets etc.,as long as you are contributing to one or both, you are making the right decision. And the best time to do it, even if you only can only do small amounts at a time, is as soon as possible.
