Choosing between a tax-free savings account (TFSA) and registered retirement savings plan (RRSP) is one of those personal finance decisions that can leave you spinning your tires like a bike messenger in February.
What’s the difference between a TFSA and a RRSP?
Both vehicles offer a tax benefit. The difference is that while there is no immediate tax advantage to be gained from TFSA contributions, neither your principal nor the investment income you earn on funds in the account are taxed when you make a withdrawal. On the other hand, RRSP contributions are deductible on your annual tax return. Effectively, RRSPs provide a tax deferral, which is to say that you're taxed when you make a withdrawal down the road.
In other words, it's up to you whether you take the tax hit now or later. Deciding which is right for you depends partly on what you earn now versus what kind of financial situation you anticipate for yourself in the future.
Which savings option is right for me?
Deciding which is right for you depends partly on what you earn now versus what kind of financial situation you anticipate for yourself in the future. "For younger people, especially lower-income people, the math might favour the tax-free savings account because they're in a lower tax bracket at the time," said Robert Brown, author of Wealthing Like Rabbits: An Original Introduction to Personal Finance.
There's another way to look at this, though. The fact that withdrawals from an RRSP are taxable is a powerful motivator for a lot of us. It's meant to make us think twice before drawing down retirement savings, and it works.
Why you should contribute to an RRSP
If you're in your early 30s and living with multiple financial obligations, there are real advantages to an RRSP from a behavioural finance perspective.
"You get the tax savings when you're 32 or 33," explained Brown. "You still have to pay the tax further down the road when you're 70 or 71. But hopefully at that time you won't have the mortgage. You won't be saving money for the kids' education. You'll be in a better overall position financially. So even if you pay a little more in taxes, it might be better from a timing perspective, because you can afford it at that stage of life."
Why you should open a TFSA
Of course, TFSAs are ideal for less long-term savings goals.
"If you're saving to buy a car, make a down payment on a house or a shorter-term thing, I'm all over the tax-free savings account," said Brown.
By the way, Brown's Wealthing Like Rabbits is excellent. It's an introduction to personal finance best practices, so it's not for everyone. But if you're looking for a smart gift for one or two 20-somethings in your life, it's a terrific, plain-language read.
- Read more about RRSPs vs TFSAs
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