RRSP vs TFSA

I wish to venture into the Registered Retirement Savings Plan (RRSP) versus Tax Free Savings Account (TFSA) debate.  If you have only so much money, and you can’t contribute the maximum to both types of savings plans, which one should you pick?

I usually start by addressing the general purpose of both types of accounts.  For RRSPs, the purpose is typically straight forward:  I’m saving now for the benefit of having a retirement asset and income later.  So an RRSP is truly a retirement savings plan.

For TFSAs, there tends to be multiple purposes:  it can be savings for retirement, to fund a surprise roof repair, for forced savings for a future purchases (new car, large vacation), or for some a quasi-casino (buy penny stocks with the hope it skyrockets and all the profits are tax-free).  TFSA’s are also unique in that if you withdraw from a TFSA you can regain your TFSA contribution room  the very next calendar year, such that you can re-contribute to a TFSA on a go-forward basis.   RRSPs do not have this type of re-contribution flexibility.

So right off the bat, the debate is clouded by the fact that a TFSA is generally multi-dimensional.   For people wanting to initiate a savings plan that can help with the following financial planning objectives, a TFSA is generally the right choice for:

1.    Starting an Emergency Fund.  It is generally recommended that you have between 3 to 6 months of your monthly cash flow needs available in savings (not debt) to handle those future emergencies that are not otherwise planned.   A TFSA is a great place to save your Emergency Fund.  You typical invest an Emergency Fund in low risk and liquid investments, such as term deposits and GICs at your financial institution.  Within a TFSA, there is no taxation applicable on the interest income earned on those investments, which allows you to keep as much of that low rate interest income as possible.  Also, a withdrawal from a TFSA is not taxable.  If you need to take the money out to address the emergency, you are not preoccupied by any taxes taken off the top of the withdrawal.   As emergencies can be multiple, the ability to re-contribute to your TFSA is also very helpful so that you can re-establish your Emergency Fund without needing to wait long until you earn new TFSA room.

2.       Saving for a Major Purchase.   We see many people make major purchases on debt, and then figure out the repayment later.  But for those of you wanting to pre-save for your major purpose, a TFSA is a great vehicle.  Similar to the Emergency Fund discussion above, you will typically purchase low risk interest bearing investments for your savings, which the TFSA allows to accumulate tax free.  And like the Emergency Fund purpose, the ultimate withdrawal from the TFSA for the major purchase is free from any taxation.  The re-contribution of TFSA room is also an advantage in this case, as you tend to have ongoing major purchase goals over your lifetime.

3.       Investing your Fixed Income portion of your Retirement Funds.  As interest income can accumulate tax-free in a TFSA, and be ultimately withdrawn on a tax-free basis, I like using TFSA’s for part of the fixed income portion of a person’s overall investment portfolio.  Interest income earned that is taxable to an individual can be taxed at income tax rates as high as 45.6% in British Columbia in 2014.  It is true that if interest income is earned in an RRSP, there are no taxes paid when you earn the interest.  However, there are generally taxes to be paid when you withdraw the amount from the RRSP.  Therefore, you achieve a tax deferral (paying tax at a later date than now) on interest income in an RRSP, versus earning the interest income tax-free (paying no taxes on the interest income) in a TFSA.

Now if the savings is purely for retirement purposes and free from the other potential uses noted above, then I generally recommend using an RRSP.   I have three main reason for this recommendation:

1.       Tax Refund Advantage.  The tax savings for an RRSP contribution, which typically manifests itself in a tax refund, is a very powerful short-term tool to gain additional financial objectives out of one long term savings decision.  A tax refund can be used to pay off debt early, fund an annual vacation, make Retirement Education Savings Plan contributions, etc.  As you don’t have to payback the tax refund until you start withdrawing the RRSP in the future, the tax refund is comparable to an interest free loan that  you can use to your discretion.  Where used wisely, the tax refund can supercharge an individual’s current and future retirement plan.

2.       Potential Tax Savings.  It is difficult to predict what income tax rates might look like 10, 20 or 30 years from now.  But generally speaking, we anticipate earning less income at retirement than we do in our working years.  Consequently, we aniticipate that the tax savings today for every $1 contributed to an RRSP will be higher than the taxes  owing at retirement for every $1 of RRSP withdrawn.  There are always exceptions to this generalization, but anything that let’s me save a higher rate of tax today and pay a lower rate of tax in the future is a good thing!

3.       Savings Discipline.  RRSPs envoke an automatic discipline that TFSAs do not:  if you withdraw an RRSP amount you pay taxes!  The moment you tell anyone that your RRSP withdraw will be taxable at a specified tax rate causes that person to hate RRSPs and taxes (they forgot the tax refund they initially got), and ultimately second guess when and how much they should withdrawal.   That is a good backdrop for a retirement savings plan, as it reduces the risk that someone saving for retirement changes their mind and starts withdrawing now monies otherwise intended for later.   Couple this with an affordable monthly RRSP contribution, and you will find that these people are saving much more for retirement than those who only use a TFSA or that only save for retirement annually.  Discipline is critical for many financial objectives, and the built in discipline of RRSPs helps people save more for retirement.

So is it RRSP or TFSA for you?  It starts with another question:  what is the purpose of your savings?

Need help?  Call me at 604-789-3888.