Spoiler alert: There is no one right answer to this question. This is not an area where rules of thumb work. Nobody can tell you that an RRSP (Registered Retirement Savings Plan) is always better than a TFSA (Tax Free Savings Account), or vice versa. Ultimately, you will be the best person to decide where to put your money, and we are here to help you understand the unique benefits of each account.
The first step is to understand the way these accounts work, the “why” behind each of them. The next step is to identify, based on this info, which account will help you reach your goals. Those goals are likely going to include a combination of tax planning, savings, investment growth, and cash flow.
Let’s get started:
The immediate tax refund: When you make a contribution to your RRSP, the government allows you to deduct that contributed amount from your income, which then gives you a tax refund. Let’s say you earn an extra $2000 at work in the past two weeks. The first step is to pay tax. If you’re an employee, the tax might be withheld on your behalf. It could be around $600, but it’s based on your tax rate. If you make a $2000 contribution to your RRSP, you will reduce your taxable income by that amount. You may have already paid taxes on that $2000, but this paid tax comes back to you in the form of a refund, which is really just the CRA giving that $600 back to you that was previously withheld. This is why it’s important to not look at your tax refund as free money. A tax refund does, however, give you access to cash all at once – which you should use strategically.
Tip: Many employers have RRSP matching programs that encourage you to save extra by putting money into your RRSP with you – that’s free money! If your work offers this plan, do you best to be a part of it.
Next, you can invest that $2000 you put into your RRSP. If you invested it well and it grows to $2,500, you don’t owe tax on that extra $500, as long as it stays in your RRSP account. Can you see the pattern? The RRSP is the government’s way of encouraging you to save – so they don’t make it easy for you to take the money out!
If you’re self-employed, it’s a bit different. You don’t have an employer paying tax from your paycheck on your behalf, so you need to save up throughout the year and pay your taxes to the CRA yourself. You are still eligible to put money into RRSP’s, and based on the timing in the year, you might get some of that tax money back.
It’s not free of tax forever, though. When you reach the time of retirement, your income is likely to be lower, therefore, your tax rate should be lower too. By the age of 71, you have to close out your RRSP – see this article for how! When you close it out, you have to pay tax on it, but at the lower tax rate.
You may be thinking, why should I put this money away and not use it until I’m old? What if I need it sooner? The CRA anticipates this and offers benefits like the Home Buyers Plan and the Life Long Learning Program to help you at times you might need it. Need a down payment? You can use your RRSP. Want to go back for a second degree? RRSP to the rescue!
To sum up, the advantages of putting money into your RRSP are:
Not paying tax today on the money you earn today
Potentially getting a refund if the tax was already paid by your employer
Access to cash when you’re buying a home or going back to school (interest free)
Paying a lower tax rate when you finally withdraw the money at your time of retirement.
Oh yes, and the original intention, of course, building up your retirement savings! If you aren’t great at keeping money aside for savings, the RRSP has restrictions on pulling money out, so it’s like a forced savings plan.
The first difference between the TFSA and RRSP, is the lack of a tax deduction. This means, that cash you were getting back as a tax refund doesn’t happen with the TFSA. So you still have to pay that $600 tax up front, from that initial $2000 you earned. From there, you can invest the remaining $1,400 you had.
The good part of the TFSA is, once that $1400 is in your TFSA account, you can invest it as much as you want and let it grow. Whenever you want to take it out, it’s tax-free! All of the growth in your money from your investments would usually be taxable at different rates, but if it grows inside the TFSA, then it is tax-free. So you don’t need to worry about waiting until retirement or wondering if you will actually be in a lower tax bracket.
The key is, your investments should get you more return than the $600 dollar hit you already took by not investing in the RRSP. That can be difficult to replicate. One strategy would be to invest in both the RRSP and the TFSA, if you have the money available. Another would be to invest in the RRSP, take the refund and invest that refund into your TFSA.
In summary, a TFSA is great for the following:
If you like to invest, your investments (up to the limits) can grow tax free.
If you want to invest in a tax-free way, but you still want to have quick access to the money in case you need it for emergencies, or just for living life!
Just remember, the cost of choosing the TFSA over the RRSP is that you have to first pay tax on the money you’ve earned. In the RRSP, you don’t need to pay tax on the money you earned. But with a TFSA, it then grows tax free and you can access it whenever you want.
There are many articles, resources, calculators, and humans out there to help you try to make the decision of using an RRSP or TFSA. Over the past couple of years, TFSA’s have become more popular, and we find a lot of young people have a negative opinion of the RRSP. We urge you to do your research, understand the accounts and consider both options.
Any questions? Share them in the comments below!