Should your savings be in an RRSP or TFSA?...or Both?
Before 2009, deciding on a savings account was pretty easy....
You either had a standard savings account earning a nominal amount of interest that you were able to dip into anytime the going got tough OR you contributed to a Registered Retirement Savings Plan (RRSP). Easy enough.
Starting January 1, 2009, the Canadian government introduced the Tax-Free Savings Account (TFSA). Essentially, the plan allows you to earn investment income (through a variety of investment vehicles) tax-free. Yes, tax-free.
A little information about RRSP’s
In a nutshell, any contributions you make to RRSP’s in a given year will reduce your personal taxable income. Your taxable income is the income that is used to calculate how much tax you will owe to the government. By reducing your taxable income through contributing to your RRSP’s, your taxes are lowered. For example, if you earned $50,000 in one year and contributed $2,000 to an RRSP account, your taxable income is now $48,000 (as opposed to $50,000 before the contribution). If you are an employee receiving a salary, any contributions you make will usually result in a tax refund from the government, and depending on a variety of factors, this refund could be quite substantial.
The caveat: Since the funds were contributed to your RRSP account before being taxed, you will have to pay tax on these funds when you withdraw the money. But the assumption is that upon retirement, your tax rate won’t be as high as when you are working, thereby reducing your ultimate tax debt to the government. And of course, your RRSP’s are working for you by earning investment income during all those years.
There are a lot more rules and regulations when it comes to RRSP’s (including how much you can contribute in a current year, when the withdrawal must be made, etc.) so please take some time to read the vast amount of literature available on the net.
A little information about TFSA’s
TFSA’s are almost the exact opposite of RRSP’s. The first difference between TFSA’s and RRSP’s is that you do not receive a refund by contributing to a TFSA. The disappointment from a client that a refund is not generated by the contribution is something accountants and financial advisors deal with on a daily basis. But, on the flip side, you can withdraw the money tax-free. There are also less restrictions and regulations in terms of contributions and withdrawals.
The beauty of TFSA’s is that any interest or gains earned on the money you contributed are tax-free. This means that you won’t be taxed on any capital gains, interest, or other investment income. This could accumulate to thousands of dollars in savings if your investments are doing well.
The caveat: As mentioned above, any contributions made to a TFSA are with after-tax dollars. This means that a contribution does not reduce your taxable income like an RRSP contribution would, and will not result in a tax refund.
TFSA’s are much more flexible and do not expire but also carry with them a maximum contribution room. Do your due diligence before deciding on opening a TFSA to ensure it aligns with your goals.
And the winner is...
Unfortunately, there is no winner. Both savings vehicles were designed by the Canadian government to help Canadians with their savings goals. The route you take largely depends on your goals, lifestyle, and discipline. For example, if you earn a large salary, it probably makes a lot of sense to contribute at least some funds to an RRSP (to reap the reward of a sizeable tax refund). On the other side of the coin, if you want to save but may need to use your savings from time to time, a TFSA account allows this type of flexibility.
After speaking with many advisors, the consensus is to diversify until you get to a point where you are comfortable with both types of accounts and are settled in your goals. At this point, you have a better idea of what works for you and where you want your money to take you. Then it’s up to you to choose a savings vehicle to get you there!
