One question I get asked over and over again (especially from newbie investors) is if it’s better to contribute to an RRSP or TFSA. Most of us have heard of both account types but not necessarily understand the differences between them. And there are differences, significant ones. Each offers its own unique advantages and disadvantages, and your specific situation will affect which account is the right choice. Today we’re going to weigh the pros and cons to help you figure out where your money should be directed.
Registered Retirement Savings Plan (RRSP)
RRSPs are meant to be for retirement; it’s right there in the name. So that makes it simple right? If you’re saving for retirement, you should be using an RRSP. Well, not so fast.
The one thing everyone loves about RRSPs is the tax refund you get when you contribute. That’s by far what they are best known for. You make a deposit and then get money back at whatever your marginal tax rate is. For example, if your income is $150,000/year you would be sitting in the 41% tax bracket. If you make an RRSP contribution of $10,000, your refund will be $4,100.
The thing not everyone understands is that RRSPs are tax-deferred plans and not tax-free plans. You have to pay the tax eventually. Your money will be able to sit in your RRSP and grow, but as soon as you start making withdrawals, you’ll get hit with a tax bill. Boo!
What’s the benefit then?
To get the benefit from an RRSP, you need to make your contributions when you’re in a higher tax bracket than when you’re making withdrawals. Let’s use the above example to break this down. We’ll keep that same $10,000 contribution you made when you were in the 41% tax bracket. Flash forward to retirement, and we’ll assume your income is now $40,000/year. This would put your marginal tax rate at 25%. That’s now the tax rate you’d have to pay when withdrawing the funds. Withdrawing that original $10,000 will result in a tax bill of $2,500. Remember how you got a tax refund of $4,100 and are now only having to pay $2,500 in tax? That difference of $1,600 is the benefit of an RRSP. And that’s just for one year’s contribution.
Lack of Flexibility
The problem with RRSPs is that they really are best when used for retirement. Sure, you’re technically allowed to make withdrawals at any point, but it rarely makes sense. You get a limited amount of contribution room (18% of your income each year up to a maximum), and you don’t get it back if you make a withdrawal. If you think you’ll need the funds prior to retirement, then it’s best to look elsewhere.
The Home Buyer’s Plan Exception
There is one time when it does make sense to use your RRSP for a purpose that isn’t retirement. There is a plan in place for First Time Home Buyers that allows them to withdraw up to $25,000 from their RRSP tax-free to buy a home. Because you’ll still get the tax refund on your contributions, it can give you a boost when saving your downpayment. Every dollar counts when you’re trying to get into the housing market.
You do have to replace the funds, but you can do it over the next fifteen years. Since you already got the refund on those contributions, you don’t get it the second time.
Tax-Free Savings Account (TFSA)
And now to the newest addition to the Canadian registered plan family. RRSPs have been around for longer than probably all my readers (1957), but TFSAs were only introduced in 2009. In that short time, they’ve become incredibly popular because they give investors a tax advantage but also a lot more flexibility.
Unlike an RRSP, you don’t get a tax refund when you contribute to a TFSA. Instead, your contributions grow tax-free, and there’s no tax when you make withdrawals. That’s right, once the money is in a TFSA you NEVER have to pay tax on it. You could deposit $1,000 to your TFSA, buy a stock that skyrockets in value up to $10,000, sell it and then withdraw that $10,000 and never pay a cent in capital gains. Outside of a TFSA, that kind of growth would cost you $1,845 in capital gains tax.
Sheltering as much of your non-registered money as possible within a TFSA can save you a lot of money in tax over your lifetime.
You only get a limited amount of TFSA contribution room each year. Unlike an RRSP, it is not based on your income. All Canadian citizens who are over 18 years old get the same amount. If you turned 18 after the 2009 start-up date then you would only have room for the years you were 18.
As of 2018, the total contribution room is $57,500. The yearly allowances have varied a bit so here’s the full breakdown:
|2009 - 2012||$5,000/year|
|2013 - 2014||$5,500/year|
|2016 - 2018||$5,500/year|
The Flexibility Advantage
Because you never pay tax, you don’t have to worry about timing your TFSA contributions based on your income. This makes them a way better option for savings goals that aren’t retirement, or even for retirement when you’re not in your highest earning years. You can deposit and withdrawal with no worries about the tax consequences. Even better, you never lose your contribution room. If you make a withdrawal, you get to replace the full amount starting the following calendar year.
The only real catch to TFSA is it needs to grow to provide the tax advantage. This is why it makes sense to hold investments and not just cash in the account. Use a regular savings account for your short-term cash needs and a TFSA for investing.
So, RRSP or TFSA?
The answer depends on the purpose of the money you are saving. If you are saving for a shorter term goal (buying a new car, going on vacation, etc.), then the TFSA is your best bet. It gives you the freedom to withdraw funds at any time without paying tax.
If you are instead saving for retirement, you then need to focus on tax rates. Will your current tax rate be higher than your tax rate in retirement? Most people’s incomes drop substantially in retirement, but there are exceptions especially if you have a large pension. In that case, you might stay in the same tax bracket for the rest of your life. If your tax rate is higher now than it will be in retirement, then an RRSP is a good option. If not you might want to consider putting your savings towards your TFSA until it is maxed out before working on your RRSP.
Shorter-term savings goals = TFSA
Retirement savings and low income = TFSA
Retirement savings and high income = RRSP
Buying your first home = RRSP
Need some help figuring out what’s best for you? Leave a comment, and I can help you out!
This post was proofread by Grammarly.