A few years ago, the government opened up a new investment vehicle for people looking to save for retirement, the tax free savings account (TFSA).
An RRSP is effectively a tax-deferred investment account. When you contribute to it, you are doing so out of pre-tax dollars (or, if you get a tax refund due to your contribution, you are getting the tax you paid on that amount back). Eventually you have to pay the piper, so when you start pulling money out of your RRSP to fund retirement, you will pay tax on that amount. The upside is that you’re able to invest pre-tax money (hence you have more of it). The downside is you’ll pay tax later on all the investment gains you make.
TFSAs are a bit different. You contribute to them out of post-tax dollars, so there’s no immediate tax advantage. While it’s harder to contribute out of post-tax dollars (you feel like you’re contributing a smaller amount), when you take the money out for retirement you won’t pay any tax on any of the gains, since you’ve already paid tax on the original investments. So the upside is you don’t ever pay tax on anything of the gains in your TFSA. The downside is you’re contributing a smaller amount in the short term.
It’s been debated endlessly about which is the better retirement vehicle. The truth is, they both have advantages and disadvantages. The TFSA is a bit more flexible, since you can add to and remove from it (should you get into a financial pinch) during the course of the year without taking any tax hit. If you’re the type of saver who is living paycheque to paycheque, having easy access to a TFSA account may not be the best option for you.
In terms of overall advantage, a TFSA is identical to a RRSP as long as your tax rate is the same at retirement as it was during your life. That’s the clincher. If your tax rate will go up during retirement, then the TFSA is the better investment vehicle for you. If you think your tax rate will go down, then an RRSP is a better vehicle.
As for me, I’ve mostly been using my RRSP as an investment vehicle, but am going to start changing my strategy to make better use of my TFSA over the next year. Each year the government allows an extra $5,000 to be contributed to the TFSA and the amount rolls over. That means I’ll have $15,000 worth of room in a TFSA, as will most Canadian’s reading this.
Personally, I’ve dabbled with both. The TFSA actually helped me pay for a flight to Santa Barbara to visit my sister a year ago. I traded a few stocks back and forth for a week and ended up netting enough (tax free) profits to cash out the proceeds pay for the flight. I look at the TFSA as a vehicle for short term goals(like vacations or buying a new car). Longer term, the RRSP or a regular non-registered account are better options for several reasons.
If you lose money on your investments in a TFSA, there’s no deduction available to you to offset some of that loss. In a non-registered account, you can claim up to 50% of the loss each year towards any gains you make in that year (or future years with carry forwards).
If you’re using leverage to invest, you’d want to use a non-registered account in order to be able to deduct the interest paid on the borrowed funds.
For retirement planning, an RRSP usually makes more sense. If you’re in your prime earning years, you’re going to want to maximize your RRSP contributions to defer income taxes and allow that money (that otherwise would’ve gone to the CRA) to compound. I’d rather defer taxes today to pay them tomorrow, regardless of the higher potential income bracket I might be in at retirement. I feel I can better leverage the money I defer in income taxes today to grow my new worth.
I’ve had years where I’ve maxed out my RRSP and also contributed to my TFSA and non-registered accounts. This is really the best of all worlds, and allows you to select what types of investments to put into what accounts.