There has been a lot of talk about which one is better, the TFSA vs RRSP in both the PF blogosphere and the media. Both are great tools for saving for us Canadians. Given that it’s a fresh year (and almost time the RRSP contribution deadline for 2011- March 1, in case you forgot), more people are thinking about the TFSA and the RRSP.
In an ideal world, one could max out both the RRSP and the TFSA. That would be ideal. Though in the real world, life happens, and it is oftentimes very difficult to be able to scrounge up the money (without having to sell a kidney on the black market-kidding!) to be able to max out both the RRSP and the TFSA.
In my opinion, the RRSP and the TFSA are like siblings. Very different siblings. Almost mirror opposites and the inverse of each other. They both compete for your money and attention. They are both good, but as we all know, one can be better for you than the other, just like parents really do have a preference of one sibling over the other, but they just don’t say it aloud (uh oh, is my middle child syndrome coming out in my post?! Sorry about that).
So let’s talk about the RRSP first (the older sibling):
The Basic Lowdown on the RRSP:
- The RRSP was introduced in 1957 (yeah, it’s the really old sibling)
- As detailed in my RRSP post, the RRSP can hold a number of things (including GIC’s, stocks, mutual funds, bonds); it’s like a basket of investments sheltered from tax
- Contributing to the RRSP is with PRE-TAX income (the tax refund you get is your pre-tax money, but given to back to you at a later date)
- You will have to pay tax eventually when you take money out of it- it’s a tax deferral program (the hope is that when you take money OUT of the RRSP, you’ll be low income aka retired, so there won’t be as much income)
- You are supposed to contribute to it to reap the tax deductions when you’re at a higher tax bracket, and take it out when you are at a lower tax bracket.
- There are two options where you are allowed to borrow money from your own RRSP: 1) Home Buyers Plan and 2) Lifelong Learning Plan (with both you are expected to pay back 1/15 and 1/10 respectively, of the amount you borrowed per year until its fully paid)
The Lowdown on the TFSA:
- People could first contribute to a TFSA in 2009 (this is the new baby sibling, becoming ever popular)
- Each year after the age of 18, you can contribute to $5000 per year to a TFSA
- Currently in 2011, if you haven’t opened a TFSA before, you can contribute up to $15,000
- Like an RRSP, you can hold a number of things. The TFSA is like a basket of investments (GIC’s, High Interest Savings Accounts, stocks, bonds etc.)
- Money contributed to it is AFTER TAX income, but you can take out money that has been compounding in the TFSA TAX FREE.
- You can take out the money any time– tax free
- You have to wait until the next year to contribute back to it, otherwise you will be dinged A LOT.
- Many people have been using the TFSA as an emergency fund, but with the increasing amount allowed ($15,000) I think people should be looking at other options for their TFSA- like my personal favourite, the Tax Free Trading Account
Do you see what I mean about them being the inverse of each other? RRSP= pre-tax dollars invested, taxed when you withdraw; and TFSA= after tax dollars invested; no tax when you withdraw. Now that we’ve introduced the siblings, lets look at their good and bad traits.
PROS of the RRSP:
- It feels awesome to get that tax return. Especially when you use that tax return to contribute to your RRSP again for the following year.
- Like Jim Yih (a fee only advisor and best selling author and financial speaker on wealth), I agree that RRSPs are great in that you are forced not to want to withdraw from it (other than for school or for a first time home purchase)… because we all know that we all have sticky fingers and it’s hard not to take from the cookie jar!
- Hence, it’s a great way to develop disciplined investing into your RRSP
- It’s a good tool for those with high incomes who are taxed to the nines. It can feel good to get some of your tax dollars back.
- You can hold USD stocks in it- great for big dividend payers stocks like Coca Cola, Johnson and Johnson etc. Because if these stocks are held OUTSIDE of an RRSP, you would have to pay hefty taxes on it because foreign income is treated like interest income- taxed at your marginal rate (e.g. if you paid 40% income tax, you would pay 40% tax on your dividend income from Coca Cola)
CONS of the RRSP:
- It’s a tax deferral… if you have a great pension, you will be taxed to the nines when you are in retirement, especially when you are forced to take your RRSP out, little by little each year.
- You can’t take money out except for buying a home (first time or very long time since you’ve bought a home) or for education for you or your spouse (up to the age of 71)
- If you aren’t making much money that year (e.g. if you are a student) there isn’t too much point in taking a deduction for the RRSP. You already aren’t taxed that much, so you wont’ get much of your taxes paid back.
- The Home Buyer’s Plan and Lifelong Learning Plan are great, but the money you pay back to your RRSP isn’t tax deductible.
Now let’s look at the hotter younger sibling, the TFSA
PROS of the TFSA:
- Everyone gets the same amount- so it could be more equitable that way. Everyone can contribute $5000 starting from the age of 18.
- So, theoretically if I contributed $5000 to a TFSA until I was 65 and had zero returns (which is highly unlikely) on my investments, I would still have a little over $200,000 in the bank. Tax Free.
- It is easy to get your money out
- You are rewarded for investing smart.
- If you invested really well and made $4000 on top of your $5000 contribution, and you withdraw $9000, you can contribute $9000 back the following year instead of $5000 (Balance Junkie proves this is true by calling up CRA to double check)
CONS of the TFSA:
- The problem is that it is being heavily marketed as a Tax Free High Interest Savings Account by all the big banks. You get 2% interest if you’re lucky, and as we all know this barely keeps up with inflation (this is understandable because with such little amount able to invest, the banks don’t want to waste their money or time if you have so little to invest with them- that’s my two cents anyways)
- With little contribution room available ($15,000 so far), it might not be feasible to invest in equities or trade very often, because this eats away at your contribution room ($29 a trade can really add up).
- It’s very easy to take money out (it’s both a pro and a con) so being able to save for something long term (like retirement) will be difficult, what with our natural tendency towards instant gratification
Personally, I am trying to contribute to both. I don’t have very much money that I am allowed to contribute towards an RRSP anyway because of the Pension Adjustment, so a little tax refund is always nice to offset some things like capital gains, interest income etc., otherwise I might be paying more taxes when I’ve already paid so much in taxes from my primary source of income.
I do like that the RRSP allows you to contribute USD. I do like that with the TFSA, it can be used as a short term mode of investing and saving. I like them both, for different reasons.
I would recommend that for those who are not taxed to the nines yet (like students, new grads, young adults etc.), it is better to contribute to a TFSA. The TFSA would be better for short term goals (within 1-10 years), like saving for a down payment, saving for a car, saving for that future baby, or saving for that big trip. The TFSA (younger sibling) is great for those short term goals. If you are able to invest well with the TFSA, those goals can become reality that much sooner. However, just as we can’t ignore the wiser, older sibling, we must not forget about the RRSP. We need to make sure we have enough to retire on too. Because compound interest and TIME is on your side (because we’re young!), once you start making some money, I would sock some money away at an RRSP for now. It’s hard to play catch up when you’re saving for retirement.
However, for the 32% of us that have a big pension to retire on, I would mainly recommend the TFSA. With $200,000 available to be withdrawn tax free and a pension, there should be enough money available for a comfortable retirement. That is unless can’t resist dipping into the cookie jar before then!
Of course, everyone is different and would have a different reason for having one or the other as a better option for their situation. It’s best to sit down and really think about the merits of each option to figure out which one you want to allocate the majority of your hard earned money to.
Readers, what do you think? What are your thoughts between TFSA vs RRSP? Are you planning to contribute to both? If you had to pick one, which would you choose?