If you live in Canada, chances are you’ve heard of RRSPs and TFSAs – at least I hope you have. If you already know exactly how they work, then skip this post. If not, read on, because there’s some stuff about them that I need you to know.
But first, remember: I’m not a financial advisor, and you shouldn’t take my opinions below as formal advice. It’s not. I’m just a guy who is passionate about personal finance, and am sharing some things I know about it. Cool? Great, let’s get down to it.
What is an RRSP?
RRSP stands for Registered Retirement Savings Plan, and it’s a tool given to us by the government that helps us save for our retirement. Say what you will about the Canadian government, this is one thing they got right. Before I detail what an RRSP is though, you need to understand one basic thing about the taxes we pay in this country. When you have an investment – whether it’s a bond, GIC, mutual fund, stocks, or just about anything else – you pay tax when it makes money. The amount of tax you pay depends on the type of investment (that’s a post for another day), but you pay tax once a year if you make money.
That’s what makes an RRSP special. Essentially, an RRSP is a designation that you give to your investments that tells the government that those investments are OFF-LIMITS for taxation. You pay no tax on them until you retire and start taking money out of the account.
“Ok, what’s so great about that? I’m still paying tax either way,” you might be thinking. Not so fast. Remember how compound interest works? If not, go back and read this post on the topic. What’s so great about the account is that all of the earnings your investments make that would have been paid in taxes to the government stay in your account until you retire, which means that those earnings continue to earn you money, in the form of compound interest.
A 20-year Example
To illustrate the value of this, let’s look at the value of $10,000 invested over 20 years. We’ll compare two scenarios: one where it’s in an RRSP account, and the other where it’s in a non-registered investment account. For the purposes of this example, we’ll assume you pay 15% tax on your earnings each year that fall outside the RRSP. We’ll also assume your investments grow by 8% per year.
In the non-registered example, you’d make $800 in your first year. You’d also pay 15% of that, or $120, to the government, leaving you with $680 in earnings. At the end of 20 years, your original $10,000 will have grown to just over $37,000. Not bad.
In the registered example, you’d keep that $800 and all future earnings in the account. Without having to pay tax, that same $10,000 in an RRSP would grow to over $46,000 over the same 20 years. That may not seem like a lot, but it’s 25% more than if you had left the money in a non-registered account. That can make a BIG difference to your quality of life in retirement! I don’t know about you, but I like to travel…
So what about those taxes? I mentioned earlier that you pay them in retirement. There are a couple reasons this is better. First, most people fall into the lower tax bracket in retirement than when they’re working full-time, so you’ll pay less tax overall. Second, even if you’re in the same tax-bracket in retirement as you were when you worked, you still benefitted from all the compound interest those tax dollars made you over the years, so you’re better off. I’d rather pay the government my taxes in 20 years than right this second!
What is a TFSA?
Ok, so now you know what an RRSP is. So what’s a TFSA? Well, they’re kind of similar in that they both allow your money to grow tax-free. TFSA even stands for Tax-Free Savings Account. Like an RRSP, you don’t pay tax on the money your investments earn you while they’re in this account.
So what’s the difference between the two? So glad you asked J
When you put money into an RRSP, you’re putting before-tax dollars in. You can claim any money you put into an RRSP each year on your tax return, and the government will give you the tax you paid on that money back into your pocket (to be paid later, when you retire). I’m not going to get into how to claim your RRSPs on your taxes – that’s yet another post for another day. For now, just know that that’s how it works.
When you put money into a TFSA, however, you do it with after-tax dollars. This means that you’ve already paid the tax on the money that goes into the account, and so you won’t pay any tax at all when you withdraw money. Sweet!
Which one is better for retirement, RRSP or TFSA?
People have their opinions on this, but the short answer is that, holding all other things equal over time, the two are exactly the same in terms of how much money they’ll save you in taxes.
Here’s one thing that breaks the tie in my opinion though. You can take money out of a TFSA any time, without penalty. This isn’t true of an RRSP. If you try to take money out of an RRSP for emergency reasons, you’ll pay two kinds of tax: regular income tax (at your marginal tax rate for that year), and also something called withholding tax. These will take a HUGE chunk out of the money you actually get in your pocket, and in my opinion you should never do this unless your house is on the line or something.
So for that reason, I recommend maxing out your RRSP before your TFSA, assuming you’re saving for retirement. It’s just way too easy to dip into your TFSA savings and sabotage your future self in order to buy that car/boat/whatever you’ve always wanted. An RRSP forces you to be more disciplined.
That said, if you’re saving for something more short-term (like a vacation or a down payment on a house), it makes more sense to use the TFSA for that!
A caution on how RRSPs and TFSAs are sometimes presented by the financial industry
Many advisors in the Canadian Financial Services industry are honest, stand-up folks who will do right by you as best they can. Others aren’t. With that in mind, please pay attention to what I’m about to say next. I’m going to put it big freakin’ quotes so it sinks in:
Just because it’s called a savings account, doesn’t mean that all you can hold in it is cash and GICs!!
I’ve heard it spun that way before: “Open a Tax-Free Savings Account and get 1.3% interest!” NO. Hell no. Call BS on anyone who says that to you. Just about any investment you can put in a non-registered account – Stocks, mutual funds, bonds, ETFs, whatever – can also be put into an RRSP or TFSA. It’s not just for low-interest short-term investments.
Think of them as a box with a label on it (revisit the image at the top of this post if you need help with that). Simplifying a bit, you can put any investment you want into the box, and it just gives the government a way to classify what to charge you tax on and what not to. That’s it. They’re NOT a specific type of investment, and don’t let anyone tell you otherwise!
A word on contribution limits
One other caution I want you to be aware of: there is a limit to how much you can contribute to your RRSPs and TFSAs each year. I won’t get into them here, but I will give you a couple resources you can check out to learn more:
Wrapping it Up
If you’re trying to save for your retirement and don’t have an RRSP or TFSA set up, get your butt off the couch and go do it. It’s the single biggest favour you can do your future self, and it can mean the different between retiring at 60 instead of 65, or being able to take four trips a year instead of one. Get on it!!
Have a question on RRSPs or TFSAs? Contact me or drop me a comment below!