Gail’s take: RRSP vs. TFSA

When it pays to save using an RRSP and when a TFSA makes more sense.

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savings_pig_322There’s a lot of yada-yada about how much tax folks will have to pay on RRSP withdrawals, and the idea of whether or not it will be worth it. It’s the big argument being used in favour of TFSAs. It’s time to clarify.

First there’s the whole idea of whether an RRSP is even worth the effort because of the way it affects other retirement income in terms of taxes. This is a two-pronged issue.

1. For people who are on a very limited income, who will likely make as much or almost as much from their government pensions (CPP/OAS) as from working, then setting money aside in an RRSP makes very little sense. Since they will be replacing most of their income with government pensions and their income is so low that RRSP contributions would affect their quality of life now, these people need to focus on an emergency fund and on having some fun.

2. For the people who will make so much from their pension (private and government) that their personal (RRSP) savings add very little more needed income, a TFSA makes more sense.

Next there’s the whole growth inside the RRSP thing. When you start contributing to an RRSP at a young age, and have 30, 35, or 40 years to watch the money compound on a tax-deferred basis, the growth inside an RRSP is staggeringly higher than outside an RRSP. Let’s say you have $10,000 to invest and your marginal tax rate is 35%. Outside an RRSP that $10,000 will grow to $21,598, assuming a return of just 4% over 30 years. Inside an RRSP you would have  $32,434. That’s $10,836 more inside an RRSP on a single $10,000 contribution. I’m not sneezing, are you?

The tax advantage is also nothing to be sneezed at. If you pay tax at 30% and put $10,000 in an RRSP, you will receive a tax refund of $3,000 that you can then use to pay down a mortgage, build educational savings or have some fun. It’s a bird in the hand now.

Please remember that the RRSP was created so people who did not have a company pension plan would have the same opportunity to build retirement assets as those lucky enough to belong to a plan at work.

There are no right or wrong answers to the RRSP vs. TFSA debate; it all boils down to “What works for you?”

5 comments on “Gail’s take: RRSP vs. TFSA

  1. I think what is important to figure out is what your expected income and tax rate will be when you retire. Putting money into an RRSP doesn't mean you are going to escape paying tax on the amount of the contribution. You are just putting it off until retirement where it is hoped your marginal tax rate will be less. If you anticipate that your marginal tax rate will be the same or more at retirement then I think it is better to contribute to a TFSA than an RRSP. That way, you can pull out your contribution amount and any capital gains or dividends tax free. In an RRSP, you are going to be paying tax on your contribution amount as well as any capital gains, dividends, etc.

    Also, it is important to consider when you are going to need your retirement money. With an RRSP you are forced to start withdrawing at 71. With a TFSA there is no age requirement or timeline for withdrawal. The forced withdrawal from an RRSP will impact your income at retirement and may kick in OAS clawbacks and other tax implications.

    So though an RRSP is a great vehicle for retirement savings, it is important to consider what your future financial situation will look like as well as what your present financial situation is.

    Reply

  2. Curious about Gail's point #2 of tax-deferred growth of funds within an RRSP… Do they not grow TAX FREE in a TFSA as well? Seems to me this is the strong point for TFSA's first for the average income earner plus no taxable penalty for early withdrawal… Compounding will result in NO TAX payable upon one's chosen retirement age and no potential bump up of taxable income and potential OAS clawbacks due to the accrued savings of RRSP contributions over time.

    Factually, most income earners cannot save more than 10% of their incomes anyways, given high home prices and greater sized mortgages required to pay for them. TFSA's would probably already provide the average income earner a 5% saving shelter ($5K) assuming a family income of $100K…

    RRSP's are really for higher income earners that are essentially trying to tax defer in a number of ways a higher than average income they are receiving with little possibility of requiring the funds early…

    My view… Save First, TFSA 2nd, Mortgage pay down, RRSP Last

    Reply

  3. Somebody explain to me the point of the TFSA? the tax is already paid on it, and the maximum 'advantage' you make per year is what? $200 bucks? big deal?

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    • It is the long term income tax savings and compound interest or earnings that makes the numbers a big deal. Just like an RRSP, it is the long term compound interest and earnings but there is no income taxes.

      You are looking at it in only based on a year or two. The key is to start early as possible. For example, a conservative investor can get 3.75% annual interest rates but compounded semi-annually with provincial strip bonds but investing $5,500 a year from say 18 to 67 years old.

      I know this is an extreme case but watch this. This person will have $771,971. He or she contributed $269,500 but $502,471 is all interest. This $502,471 taxed at say 30%, would of cost $150,741 in total income taxes or on average per year $3,076.35.

      It is not $200 a year but much greater at $3,076.35 per year. Even if you saved 50% of this, $1,538.18 less a year in income taxes. It is much more than $200 a year. Remember, this is per person in a family, a spouse and adult children 18 years and older, son and daughter-in-laws save this each.

      This means 6 different persons, $18,458.10 saved annual income taxes or $9,229.05 in saved income taxes per year at 50% of this amount. The $200 a year figure is not even close.

      Reply

    • Interest rates will normalize on provincial strip bonds to 4.60% or higher in coming years which just back in 2009, 2010, 2011 were 4.60% to 4.95%, the same example of $5,500 a year contributed TFSA’s from 18 to 49 years old will be worth much more $1,007,828 versus $771,971 at 3.75% interest rates.

      The total contributions are still the same at $269,500 but the total interest is $738,328 and total income taxes saved is $221,498.40 or $4,520.38 per year. If you just saved 50% of this, it is $2,260.19 per year in saved income taxes. Remember, this is just one person. Many Canadians are using their TFSA’s as ATM machines taking money in and out and getting the 3.75% or higher annual interest rate or return compounding semi-annually or at all.

      They are not getting the full benefit of their TFSA’s because of bad financial habits and investments meaning too risky or too low of interest rates, 1% or 2%.

      Reply

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