TFSA vs RRSP: Which one is better for you?
The answer is "it depends." It depends on your situation. Before I dive into this answer, allow me to explain the difference between a TFSA and an RRSP. TFSA means Tax-Free Saving Account and, as the name indicates, it is a saving that is not taxable. When you invest in a TFSA, the income earned on this investment is tax-free, and you can cash it without any tax consequences. RRSP means Registered Retirement Saving Plan. It is meant for retirement. When you invest in an RRSP, it lowers your taxable income by the amount you contribute. As a result, you pay fewer taxes in the year you contribute as long as you have earned income that year. However, when you cash in the RRSP, the amount cashed is subject to tax.
Contribution limit and flexibility The allowable TFSA contribution limit is an annual fixed amount per individual. It is the same for everyone. In contrast, the RRSP contribution limit is a function of your prior years' earned income, unique to the individual. Still, TFSA offers more flexibility than RRSP for two reasons: (1) your contribution room remains after you withdraw money from a TFSA, meaning you can contribute the amount withdrawn in future years, whereas for an RRSP, once you cash the RRSP, you don't get this contribution room back, (2) for the RRSP, you are forced to start to cash it in and report as income after you turn 71, whereas there is no such condition for TFSA. RRSP is worthwhile if your marginal tax rate in retirement is expected to be lower than during your working year. However, the RRSP taxable income in retirement may have a detrimental effect on the amount you receive as OAS (Old Age Security) and GIS (Guaranteed Income Supplement). For this reason, it is sometimes better to stick with TFSA over RRSP.
Finding the right answer for you It is difficult to determine what is best for you because you would be betting on the future. If your financial future looks bright, then RRSP is detrimental as it has the potential to increase your taxable income in your retirement years to a higher marginal tax rate than your working years and lower the amount that you could get from OAS and GIS. If your financial future looks bleak, i.e. you will have less income in retirement than in your working years, maximizing your RRSP would work better. How do you decide between TFSA and RRSP? Each situation is unique and has to be looked at in the context of how we think the future will turn out and what actually happens. My rule of thumb I suggest to my clients to try to first maximize their TFSA because of its flexibility. It's a great vehicle to house an emergency fund, saving in short-term liquid investment. It's also a great place to save for future purchases, e.g. next car, next vacation. If they still have saving room after contributing to the TFSA, I suggest paying off their debt, including maximizing their mortgage payment. If they still have saving room after maximizing their TFSA and mortgage payment, I suggest investing in some RRSP to decrease their taxable income to a lower marginal tax rate. For this, I have to look at their unique situation to recommend an amount. Usually, the suggested amount will correspond to what would lower their taxable income to no less than $50,000. In conclusion There is no right or wrong answer. In general, if someone has the financial discipline to plan for their retirement, then it is likely that this individual will have more than sufficient income in retirement. In this case, too much RRSP will probably have an unfavourable tax consequence on the amount of tax payable and government benefits such as OAS and GIS that the person could earn. And so, I believe for most financially savvy individuals who plan for their financial future, TFSA probably works better for them than RRSP. I have not talked about another option to consider after TFSA and RRSP, and that is RESP, Registered Education Saving Plan. This will be the topic of my next blog, which will address saving for your child's education. As always, if you have any questions, please let me know. I would be happy to help you get your financial house in order.