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 savings and investing tools for us Canadians, but there are important differences between and choosing correctly between the Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP) can save you thousands of dollars in the long-term.
In an ideal world, one would max out both their RRSP and the TFSA. In the real world though, life happens. It is oftentimes very difficult to be able to scrounge up the money (without having to sell a kidney on the black market) to be able to max out both if your tax-advantaged accounts. (Which is why I recommend using a pre-authorized contribution plan to your discount brokerage account or setting up a pre-authorized “set it and forget it” investment solution with one of Canada’s robo advisors to pay yourself first!).
In my opinion, the RRSP and the TFSA are like siblings. Not twins mind you – but siblings with different personalities. In some ways they are almost mirror opposites and the inverse of each other. Both options share the trait that they allow you to shelter your investments from taxation – allowing your money to grow tax free using a wide variety of investment options. Each have their time and place, and are fantastic tools in their own way, but as we all know, one probably deserves more of your attention than the other (just like parents who really do have a preference of one sibling over the other, but they 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)
- The RRSP can hold a number of things (including GIC’s, stocks, mutual funds, and bonds); it’s like a basket of investments sheltered from tax.
- Contributing to the RRSP is done 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 – it’s a tax-deferral program. The hope is that when you take money out of the RRSP, you’ll be at a lower income than when you put money in (aka retired), so the average tax rate that you pay on the savings/investments will be lower.
- 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 in a lower tax bracket.
- Your maximum RRSP contribution is calculated by calculating 18% of your gross income or $25,370 (as of 2016) – whichever is lower. Any unused contribution room can be carried forward to the next year.
- There are two options where you are allowed to borrow money from your own RRSP (but it has to be paid back later):
- Home Buyers Plan ($25,000 max)
- Lifelong Learning Plan ($10,000 per year, $20,000 total max)
The TFSA Lowdown:
- People could first contribute to a TFSA in 2009 (this is the new toddler sibling, becoming ever more popular).
- Each year after the age of 18, you can contribute to $5,500 per year to a TFSA. (It is indexed to general inflation after briefly being raised to $10,000 per year – with no indexing – under the Federal Conservative government in 2015.)
- Currently in 2016, if you haven’t opened a TFSA before, you can contribute up to $46,500!
- Like an RRSP, you can hold a number of things within the TFSA. The TFSA is like a basket that you put investments into. (GIC’s, High Interest Savings Accounts, stocks, bonds etc.)
- Money contributed to TFSAs is done with AFTER TAX income – meaning that you don’t get a tax refund because the money you put it was done after you paid taxes on it.
- You can withdraw money any time – tax free!
- If you withdraw money, you have to be careful about making contributions back into your TFSA within the same year. It’s kind of a weird rule, but the TFSA only gives you back your contribution room during the following calendar year. For example, if you have maxed out your TFSA contribution, then you withdraw $2,000, you can’t put $2,000 back into your account later in the year unless you want to pay a penalty. Instead, in 2017 you would have $7,000 worth of contribution room available.
- Many people have been using the TFSA as an emergency fund, but with the increasing amount allowed ($46,500) I think people should be looking at other options for their TFSA. If you use the TFSA to invest in long-term equities, you can shelter a substantial amount of investment earnings in your TFSA. Would you rather shelter the 1% you are getting in a high interest savings account, or the 7-8% a balanced index ETF portfolio could snag you?
RRSP = pre-tax dollars invested, taxed when you withdraw
TFSA = after tax dollars invested, no tax when you withdraw.
Now that we’ve introduced the siblings, let’s 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 supercharge your RRSP contributions for the following year.
- RRSPs are great in that you are sort of forced not to withdraw from it (other than for school or for a first time home purchase) because of the tax hit you will take if you do so. We’re all human, and if we know that money is accessible then it’s hard to keep sticky fingers away from the cookie jar! Consequently, using an RRSP is a great way to develop disciplined investing habits.
- It’s an especially 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 and then defer your investment returns until you retire to a lower tax bracket.
- RRSPs are perfect for holding stocks and ETFs from the USA. This is because of a tax treaty that Canada and the USA have when it comes to taxation of dividends. It can get kind of complicated (if you want the in-depth explanation, here’s a good place to start), but suffice it to say that RRSPs are a great place to park US-based equities.
CONS of the RRSP:
- It’s a tax deferral… so if you’re fortunate to 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 when you turn 71 via Registered Retirement Income Fund (RRIF). Some people end up paying an even higher tax rate than they would have during their early working years.
- You can’t take money out penalty-free except for buying your first home or under the Lifelong Learning Plan.
- 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 and chasing a big tax return via an RRSP contribution. You already aren’t taxed very highly (if at all), so you won’t get much of your taxes paid back. Better to use a TFSA here.
- If you don’t re-invest your tax refund (woo hoo Caribbean trip!), then you lose out on the pre-tax advantages. Most Canadians gloss over this little detail.
Now let’s look at the flashy younger sibling, the TFSA
PROS of the TFSA
- It’s a very flexible savings tool that allows folks to take money in and out of a tax-sheltered account easily and without penalty.
- TFSA investments have already been taxed, so unlike your RRSP investments, you can safely determine exactly how much money you can take out when you retire. RRSP withdrawals of course are subject to whatever new tax rate comes out.
- When you retire and started pulling money out of your RRSP and TFSA accounts, as well as collecting government payments such as Old Age Security (OAS), the government takes your RRSP withdrawals into consideration when “clawing back” your OAS – but this is not the case when withdrawing from TFSA.
- Just like the RRSP, your investments can compound inside your TFSA tax-free (this can make a HUGE difference if you start at a young enough age).
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. This misinformation means that people are actually severely misusing their TFSA. I’m in favour of renaming the entire package to a Tax-Free Investing Account. This would give people a much more accurate view of the ideal way to use the tax-sheltered account.
- The majority of Canadians still earn significantly more during their working years than they do in retirement. This usually tips the balance in favour of RRSP contributions.
- Because it’s so easy to take money out of a flexible account such as the TFSA, human nature might tempt you into making decisions that are not conducive to building long-term wealth.
- Some employers only offer pension-match contributions for RRSP contributions. If this is the case – then ignore everything else take the free money your employer is offering!
There is more to choosing where to place your hard earned savings than tax considerations. Here’s a great tool that we borrowed from a friend. Don’t be afraid to ask questions in the comment section below!
Young and Thrifty’s Take:
The short answer when it comes to the TFSA vs RRSP debate is: “Yes… DO IT.” Truthfully, the real danger here is paralysis by analysis. Picking the “wrong” one (the better term might be “slightly less efficient one”) is still much much better than not saving at all!
Personally, I am trying to contribute to both my TFSA and RRSP Questrade accounts in order to take advantage of each’s unique characteristics. 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. Being that I’m in a relatively high income tax bracket right now, some RRSP contributions make sense; however, I am one of the very fortunate souls that will also have a nice pension to depend on when I retire (assuming I don’t get fired!) so going all-in on RRSP contributions isn’t my favoured approach.
I would recommend that for those who are not paying a relatively high level of taxation it is better to contribute to a TFSA. The TFSA is 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. As we discussed before however, the TFSA is actually best used for long-term investing. It is like the Swiss Army Knife of registered accounts.
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.
2017 RRSP and TFSA Update
Before last year’s federal election there was considerable noise about changing the TFSA and RRSP – but with a Liberal win the registered plans remain very similar. Our former Prime Minister had promised to raise the amount allowed under the Home Buyers Plan to rise to $35,000 and decided to put the TFSA annual contribution up to $10,000. Following the election, the $35K home buyers plan option was taken off the table due to concerns about rapidly rising housing prices (personally I think saving for your downpayment using an high interest savings account from an online bank within your RRSP is still the most efficient way to get into a house ASAP). Canadians got to enjoy one year of the $10,000 TFSA before the rules revered back to a $5,500 annual contribution limit that will be indexed to inflation. It is good to note though that Canadians will get access to that $10,000 limit whenever they have the ability to save in life as the annual contribution room in both the Tax Free Savings Account and Registered Retirement Savings Plan accumulates and is not a “use or lose it” proposition.
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?