RRSPs or TFSAs?

So you’ve set aside some money to save for a registered savings account. Question is, what should you use, an RRSP or TFSA? What’s the real difference between the two anyways?

The key difference between a TFSA and an RRSP is that a TFSA uses what’s referred to as after-tax dollars, while an RRSP uses before-tax dollars. When you contribute funds to an RRSP, you get to deduct that contribution amount from your next year`s net taxable income on your tax return. In other words, you (temporarily) avoid paying taxes on that contribution amount, until you cash the RRSP upon retirement. Which means that a good portion of the benefit of an RRSP is used at the time of the contribution. An RRSP contribution is therefore a tax break.

On the other hand, a TFSA contribution doesn’t receive any special tax treatment. It’s considered after-tax because whatever contribution you make is made using funds that have already been taxed as ordinary income. The tax-free part of a TFSA involves the interest – all interest, dividends, capital gains, etc. earned in a TFSA is completely tax free, forever, as long as the money stays inside the TFSA.
There are some other differences that were discussed in the previous post. But the aforementioned difference drives most of the strategy involved with RRSP vs TFSA contributions. A big part of the benefit of an RRSP is immediate; that is, the current tax deduction on your next income tax return. This tells us a lot about whether to contribute immediately to an RRSP. If you are young, and you expect your income to increase substantially within the next few years, it may be smarter to wait for a few years to make your RRSP contribution, because the tax break you will receive is greater if your marginal tax rate is higher. As was discussed in the previous post, your contribution room grows over the years if you haven`t used it up previously. Furthermore, if your income is low right now, and your tax bill is very small to begin with, making contributions to your RRSP can be detrimental to your financial position. You’ll get a income tax deduction, but if you’re barely paying any taxes now, what use is that to you? Better to just invest your savings in an unregistered account and save your RRSP contribution for future, higher earning years.

Does the same concept apply for TFSAs? Absolutely not. As long as you’re paying even a dollar of tax, a TFSA will lower your taxes immediately. Furthermore, since there’s no immediate income tax deduction for the principle amount invested in a TFSA, it makes no difference whether you save your TFSA contribution room for now or later. In fact, in my opinion, every person should have maxed out their TFSA contribution already. That’s $5,000/person for 2 years running now. The only reason why your TFSA shouldn’t be used up is because all your savings are already being kept in another registered account, such as an RRSP or RESP.

If you are already earning a high income and your marginal tax rate is relatively high, then it perhaps makes more sense to use up your RRSP room before your TFSA room. If all your RRSP room is used up and you still have savings left over to invest, then start on your TFSA.

Anyways, point is, if you haven’t set up a TFSA yet and have some money in the bank in a savings account, go to the bank immediately and set one up.

The next question is, how should you invest your TFSA or RRSP money? Should your riskier, potentially higher-earning investments be put in a registered or unregistered account? The experts are pretty much divided on the issue. For investments that are safer and steadier, some experts believe that it’s better to put them in a registered account, since 1)it’s guaranteed to produce taxable gains, interest, dividends, etc. (as opposed to riskier investments, which can lose money in any given year) and 2)because the fact that it’s steadier means that taxes affect it more in the long run. Other experts believe that simply higher earning investments have the obvious potential for higher taxes (since the gains can be much greater), and therefore it’s better to put your riskiest investments in a registered account.

Personally, I think it’s completely your choice. The most important thing is that you are saving money and putting it away. That’s 90% of the battle. Obviously you should ask your financial advisor for his opinion in any case.

One obvious point is: Remember when I told you that every family should have an emergency fund (at least) equal to 3-6 months of living expenses saved away in risk-free investments? Those funds should not be prioritized ahead of riskier investments in terms of placement in a registered account, because taxes will be minimal on those investments. Remember, RRSPs and TFSAs help you grow your savings in a more efficient manner, without taxes impeding them. If your investments are not focused on growth, than they should not be in your TFSA. Nonetheless, obviously if you have no other savings, you might as well put the emergency money in your TFSA, to gain whatever tax break is possible.

Next post, I will discuss Registered Education Saving Plans - stay tuned!