010 Where to park my money: RRSP or TFSA?

Question from a reader

Hi Alain, when is better to invest in a TFSA (Tax-Free Savings Account) rather than an RRSP (Registered Retirement Savings Plan) if you have room in both? Thanks.

Answer

Thank you reader for your question. (If anyone else would like to ask a  question, please send it my way, I will answer it in public.)

I will start with the official government answer.

According to the government of Canada, this is the definition of the RRSP and this is their definition of their TFSA.

How I understand RRSPs

The RRSP is money that you invest before being taxed.

Imagine that your taxable income is $40,000 per year.

If you decide to invest $5,000 in your RRSP your taxable income will become $35, 000 ($40,000 – $5,000 = $35,000).

You can invest those $5,000 in stocks, bonds, mutual funds, or ETFs or any other investment vehicle authorized by the government.

Your investments will grow in the way of capital gains, dividends, or interests.

When you withdraw your initial investment of $5,000 plus whatever gains you made, that money will be taxed.

People refer to this as tax deferral. Instead of paying your taxes now, you will pay your taxes many years into the future, ideally when you have a lower tax bracket. So most likely you will be paying a lot less in taxes.

The most common RRSP strategy is to contribute money every year and then, at retirement time, when you no longer have a regular income, then you can start withdrawing your money. Ideally, your tax rate will be lower because you no longer have a job and will pay lower taxes.

Keep in mind that because your withdrawal from your RRSP is considered regular income, it can affect your Old Age Security pension and your  Guaranteed Income Supplement. To qualify for some of these programs you have to earn below certain income levels. If you are still earning lots of money from your RRSP then you will not be able to qualify. Think of RRSP as money you earned a long time ago, but you are only declaring now. Your RRSP income is the same as regular income.

When doesn’t it make sense to put money in RRSPs?

• One of the most enticing things about the RRSP is being able to pay taxes 10, 20, 30 years later instead of paying them today. But if your taxable income is so low now that you hardly pay any taxes, then the RRSP loses its charm.
• People defer their taxes thinking that they will be in a lower tax bracket at age 65, but for some people, income doesn’t come down, income comes up. Imagine that you are an author. At the beginning of your career, your income was low, barely enough to survive, but at age 65 you have become very popular, you get many speaking engagements and you are at the peak of your career earning more money than ever. It doesn’t make any sense to protect your income from taxes when you are broke, to pay those taxes at a higher tax bracket when you are earning a lot.

Some more information about RRSPs

Contribution limit. There is a contribution maximum limit of 18% of your income. If you do not contribute the maximum in any particular year, you can always catch up the following year.

Foreign assets. Canada is only 2% of the global economy, yet most Canadians have most of their money in Canadian equities. I suggest diversifying globally and the RRSP allows you to buy securities in most international markets.

Withdrawing money before age 65. You can withdraw money from your RRSP at any time. The drawback is that this money will be considered taxable income. Let’s go back to our previous example. You are still earning $40,000, but now, instead of putting money into your RRSP, you decide to take money out from your RRSP, let’s say you take out $10,000. Now your taxable income is $50,000 and your tax bracket is probably higher, so naturally, you will pay more taxes.

Maybe some of the best time to take the money from your RRSP is when you are unemployed. If you are not earning any income, and you take money out of your RRSP, then the consequences are not different from taking out at retirement time.

Taking out money without suffering tax consequences. The government allows you to take money out of your RRSP, without adding it to your tax bill, when you decide to buy a house or when you decide to go back to school.

Under that First Time Home Buyers’ Plan, the government allows you to borrow up to $25,000 from your RRSP, in other words, you are borrowing money from yourself and you have a time limit of 15 years to pay it back.

Under the Lifelong Learning Plan, the government allows you to borrow $10,000 per year for two years from your RRSP and you have a time limit of 10 years to pay it back.

For how long can you contribute to your RRSP? A person is allowed to contribute until age 71. After you reach 71, then you have to start a plan to start withdrawing the money. You can withdraw everything in one check (which is not advisable and have detrimental tax consequences) or convert it into a Registered Retirement Income Fund (RRIF) and withdraw the minimum allowable amount every year (More about RRIF in future articles).

How I understand the TFSA

As the name implies, a Tax-Free Savings Account is an account where you can earn money tax-free.

You can have a variety of investments in this account; stocks, bonds, mutual funds, index funds, ETFs, etc.

The money you have deposited in the TFSA is after-tax money. This means you have worked for this money and you have already paid taxes on it.

In my opinion, the biggest limitation of the TFSA is that you are only allowed to contribute a limited amount of money. For 2018 that amount was $5,500. The government will increase that amount in the future. If in any particular year you didn’t contribute the maximum, you can always catch up the following year.

You can take money out of your TFSA at any time you want, and you don’t have to pay any taxes or penalties. You don’t have to give any explanation. You just take it out and spend it whichever way you want.

What’s my technique? RRSP or TFSA

Because my income is low, I receive no tax benefit from contributing to my RRSP. In addition, because I am a freelancer, I think that my income will increase over time. There is no reason to defer my taxable income now when I earn so little and to pay taxes later when I think I will be doing much better.

At the beginning of every year, I contribute the maximum allowable for the year. My returns have not been extraordinary, but they are tax-free :). I can take the money out whenever I want to, without any penalty, and that has great value to me.

What should you do? TFSA or RRSP?

It all depends on your income. If you have a low-income, don’t even consider the RRSP. If your income will be higher at age 65 than now, don’t consider RRSP either.

On the other hand, if you have a stable job, with a high salary and you will no longer have that job after you retire, maybe RRSP is the best for you. You might lose out on some of the government benefits, but those benefits are small and your accumulated assets within your RRSP should be quite substantial.

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