Wise Wizzard Words

Should you invest in an RRSP or a TFSA?

Pros and Cons of RRSP vs TFSA

Screen Shot 2019-07-01 at 6.52.58 PMIf you ask someone which is better for your money you will get differing opinions. So, let’s explore how each works and you can decide how to spend your money.

RRSP

What is it? A registered retirement savings plan is a method for Canadians to save money for retirement.

How does it work? You put money into an RRSP by first setting up a plan through your bank or investment advisor. It has to be registered to get the benefits.

The money is then invested in a vehicle of your choice. You can put it in guaranteed investment certificates (GICs), exchange traded funds (ETFs), stocks, bonds, high-rate savings account, etc. But you need to do something – you can’t just put it in an account that earns little or no interest and leave it there.

Why can’t I leave it in a savings account? Because the whole purpose of an RRSP is to have the income and growth in the investment protected from Canadian income tax. So, if you don’t earn much it won’t grow much either.

Why would I want an RRSP? Every dollar invested in an RRSP in a year reduces your current income for tax purposes. Therefore, you pay less tax. This provides a benefit in the year you make a contribution. It also means you have money being saved for your retirement.

When you take the money out of your RRSP it is taxed at the rate in place in the year you take it out. The theory is you would be in a lower tax bracket in retirement and therefore be taxed at a lower rate.

What else is an RRSP good for? There are a couple of initiatives that are currently available with an RRSP. First, you can take money out of your RRSP to use for a down payment on the purchase of a home. There is a maximum of $25,000 and it needs to be repaid over 15 years, as of the writing of this. Secondly, you can borrow from your RRSP to increase your education. (More details can be found on the Government of Canada website 

Also, because you cannot take the money invested in an RRSP out before retirement, you are essentially encouraged to save it.

What is bad about an RRSP? One thing to be aware of is you can only contribute to an RRSP if you have “earned income.” To be “earned” means that you have to do something to get it, like being employed, self-employed, or have rental income. So, investment income is not considered earned income.

There is a maximum of 18% of your earned income that can be contributed to an RRSP in any one year. If you want to use any of the money from an RRSP you will be taxed on it in the year you take it out (unless it meets the government’s house purchase or education rules).

TFSA

What is it? A tax-free savings account is a method for Canadians to save money.

How does it work? You put money into a TFSA by first setting up an account through your bank or investment advisor. It has to be registered as a TFSA to get the benefits.

Money, up to a maximum, is then invested in a vehicle of your choice. You can put it in guaranteed investment certificates (GICs), exchange traded funds (ETFs), stocks, bonds, high rate savings account, etc.

Any income generated from your investment is not taxed.

Why can’t I leave it in a savings account? You can! The TFSA can be a savings account that earned little or no interest. It is your choice. But not investing it means you aren’t really taking advantage of the purpose of a TFSA. (Which is to not have the income earned from the investment taxed.) 

Why would I want a TFSA? You would want a TFSA so you can earn interest, dividends, and capital gains from the money invested and not pay any tax on the income like you otherwise would.

So, you can save and grow your TFSA without paying any tax on it.

What else is a TFSA good for? You can take money out of your TFSA and still not be taxed on it.

You can also put the money you took out, at its market value, back in as long as you wait until the year after the removal.

What is bad about a TFSA? You can only contribute a set amount each year, as determined by the Canadian government. You can’t start a TFSA until you are 18 years old. (This might be 19 in some provinces).

Comparing RRSP to TFSA 

Let’s say you are 30 years old and have been working full time since you were 22 at a job that has paid you $60,000 per year (I’m averaging here for simplicity). You pay income tax on your earnings at a combined tax rate of 30%.

First, let’s look at the amount you would be able to contribute to a TFSA and an RRSP.

The TFSA didn’t exist until 2009, so although you were old enough to have a TFSA at 18 years old, it doesn’t count until you are 20.

You can see from the table that you would be able to contribute $97,200 to an RRSP and only $63,500 to a TFSA. So, if they both earn the same rate of return the RRSP would grow faster.

Next, let’s assume both the TFSA and the RRSP earn 5% return a year after any fees.

The following table shows you what your accounts would be worth in 2019 including the 5% earning rate.


So, if both the TFSA and the RRSP earn 5% each year the balances would grow to $85,128 and $125,041 respectively.

Finally, you need to look at the tax impact of the TFSA compared to the RRSP. Now, while neither account is taxed on the income earned while it is growing, the RRSP gives you a tax reduction each year you contribute. Let’s look at one year as an example of this effect. Remember the tax rate is assumed to be 30%.

 

So, you pay less tax by contributing to an RRSP than you would if you contributed to a TFSA.

However, there is one other difference. The income built up in the RRSP would be taxed when you take it out whereas the TFSA would never be taxed. In this example, you wouldn’t need to take any money out of your RRSP until you retire – which is likely more than a couple of decades away.

In summary, I have laid out the basics of how the RRSP and TFSA savings mechanisms work. This is meant to help you make your own decision regarding where to put your savings.

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