If you live in Canada, then you are familiar with the RRSP vs. TFSA debate. The on-going debate of which is a better option for long-term retirement planning, an RRSP or a TFSA?
Let’s look at the fundamentals first:
What is an RRSP?
An RRSP is a Registered Retirement Savings Plan (RRSP) that was established in 1957. This year (2017) would mark 60 years since it’s inception. It is an option that many Canadians use to save for their retirement.
The amount of money you can contribute into your RRSP is determined by the income reported. So, to grow your RRSP room, you need to be earning an income. The “income” figure used to calculate your RRSP room is not just employment income, but includes other forms of income. The amount of room each year is 18% of your ‘qualifying income’ to a maximum amount. Once you have started growing your RRSP contribution room, you can begin putting money towards it. Some of the things to note with RRSP include:
- There is no age limit for when you can contribute into your RRSP. Most people however will build up the room when they are younger through lower paying work, and start contributing money into their RRSP as their income rises.
- You can put all types of investments in your RRSP. Your RRSP can be invested in cash, GIC’s, individual stocks, bonds, index mutual funds, ETFs, etc. Any gains earned while in an RRSP are not taxed until retirement (tax deferred) or when you take the money out.
- Money in your RRSP is ‘tax-deferred.’ The money contributed into your RRSP can be used to claim a deduction on your tax return. When and how much of a deduction you decide to take will require tax planning but the ideal result is to lower your taxable income by the deduction and hopefully get a big tax refund. However, at retirement, the deduction plus all profits made while invested will be taxed at your tax rate come retirement.
- You must start taking money from your RRSP by age 71. The government won’t let you defer paying tax forever, at some point, they want their cut. Monies in an RRSP must be collapsed into a RRIF or an annuity by 71. The amount of money you must withdraw each year depends on your age and/or your spouses age
What is a TFSA?
The Tax-Free Savings Account (TFSA) was established in 2009. It’s an option that fewer Canadians take advantage of but is growing in popularity for many Canadians.
Your TFSA room (the amount of money you can contribute in a TFSA) is determined by:
- Your age. Must be 18 years of age or older to open and contribute into a TFSA
- Your residency. Must be a Canadian resident to both contribute and accrue a contribution room. Contributions made while a non-resident are subject to a 1% a month penalty tax.
- Yearly contribution maximum set by the government. Each year, the government determines the amount of TFSA room available for qualifying residents. This amount can be added to your total unused TFSA room.
Like an RRSP, you can put all types of investments in a TFSA. Monies in a TFSA are from ‘after tax dollars.’ Investments held in TFSA’s are tax-free, meaning you don’t have to pay tax on any profits made from your investment (on the flip slide, you cannot claim any losses either).
Okay. Now that we have that out of the way, let’s look at the arguments.
Here are 3 common statements regarding RRSP’s and TFSA’s.
RRSPs are a better retirement tool if your income is higher before retirement (and lower during retirement). TFSA’s are better if your income is lower before retirement (and higher during retirement). That is true, but most people don’t consider all ‘taxable income’ during retirement. For many Canadians, income during retirement could come from their RRIFs, Old Age Security (OAS), Canadian Pension Plan (CPP), unregistered accounts, rental income etc. All taxable sources of income that could push someone to another tax bracket, or at the very least, have them pay more tax then expected. Depending on what you are entitled to and what income generating investments you have, this could significantly impact your future income tax calculation. Granted, this is a nice problem to have. Realizing that you have more retirement income then you need. For the younger generation, future taxable income may be hard to determine, but it is also one of the reasons that make the RRSP vs. TFSA debate difficult to answer. Some serious tax planning and long term projections are needed, but as you approach retirement it may become easier to find out which option is better.
A TFSA is better because you can decide when and how much you want to withdraw from your TFSA without the government charging you a penalty tax? Also true, but I think taking this stance changes the argument all together. If we are talking about retirement, then we are talking about a ‘long-term plan’ requiring multiple decades to accomplish for most Canadians. We aren’t talking about the small percentage of Canadians that retire at 30 or 40 years old. Whether you are talking about RRSPs or TFSA’s you still need time and a decent rate of return to see your retirement nest egg grow. Taking out money from your TFSA to cover an emergency or meet other expenses may not cost you anything in taxes, but it can in lost time and compound interest.
I also must address the issue of where these monies are invested in a TFSA. If you are invested in the stock market and your investments are not doing well when you need the money, then withdrawing your funds when they have reduced in market value can be more of a financial hit than a hefty tax penalty. An alternative solution to avoid this problem is to implement a 6-month emergency fund. You can decide to put monies for your emergency fund in an unregistered savings account which maximizing your TFSA room. Alternatively, you can decide to use some of your TFSA room for short term savings (where you keep your emergency fund) and some for long term investing.
You can use the refund generated from your RRSP deductions to contribute even more to your RRSP, making your money go further. Good point, but again I address my point in argument #1. Would that be a good idea if you haven’t or don’t know what ‘all’ the sources of your income will be during retirement, not just money from your RRSP. If you have done the math and worked out the tax implications when your 65+ years old and older, that is great. However, if you are decades away from retirement, then I am guessing probably not. There is a bigger and probably even more important concern that needs to addressed. Most Canadians don’t maximize the use of their tax refunds but instead typically use it to buy consumer products or services (i.e. electronics, vacations etc.). These things are not bad in and of themselves, but to use the RRSP over TFSA argument to boost your refund assumes most people use their refunds effectively, which they don’t.
So what should we really be focused on? Getting Canadians to save more…period.
- Canadians aren’t saving enough money…period. 70% of Canadians don’t have an emergency fund and almost 50% of Canadians live paycheque to paycheque.
- Many Canadians are living beyond their means to fund a lifestyle they cannot afford.
- House prices are increasing faster than economic fundamentals can allow, resulting in a disproportionately large percentage of household debt to be mortgage debt. In major cities like Vancouver, Toronto and even Calgary many people are afraid to sell in fear of not being able to afford to get back into the market and many millennials are unable to buy because house prices are increasing faster than incomes. Inability to sell or buy, locks in equity needed for retirement savings.
- With expensive monthly mortgage payments, the discussion between RRSP & TFSA is not as relevant as many millennials cannot afford to manage their home and save.
- The younger we are, the harder it is to determine whether our taxable retirement income will he higher or lower than it is now.
- Even if we could safely predict how much retirement income we will need, our preference on how and when we want to start retirement may change, requiring us to draw from our retirement income as needed.
- With the speed of government spending, there is no guarantee that CPP or OAS will even be an option for the younger generation when they retire. Governments and policies change all the time.
- Just start saving more, anywhere. Just save
- Balance between TFSA and RRSP contributions because you don’t know what life has in store. My husband and I contribute to our employer RRSP matched savings program and use the tax refund to contribute to our tax refund.
- Maximize your tax refund to either save or pay off debt. With either approach you are ahead of most people.
- Live your life and don’t stress about things you can’t control