Comparing RRSPs And TFSAs

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.