RRSP vs TFSA: 2 effective ways to save

Registered Retirement Savings Plans (RRSPs) and Tax Fee Savings Accounts (TFSAs) are both great tax sheltered ways to save and invest.

The difference between the two lies in their tax treatment, but they are really mirror images of each other. With a TFSA you make the contribution in after-tax dollars. With the RRSP you get a tax break now and pay the tax later.

The RRSP advantage

When you make an RRSP contribution, you get the a deduction (42.5 cents per $1 at the average tax rate) and the investment grows tax-free. You pay tax when money is withdrawn, often beginning  at age 71 when an RRSP must be converted to a Registered Retirement Income Fund (RRIF). A RRIF is essentially an RRSP in reverse.  The rules require you to withdraw a certain amount each year so that Ottawa can get its tax back.

The TFSA advantage

A TFSA contribution is made with after tax cash. There is no deduction, but the money grows free of tax. It also comes out free of tax. That’s why Wealthy Barber author David Chilton days  TFSAs are the ‘Totally Fantastic Savings Account.’

TFSA’s were introduced in 2009 with a $5,000 limit that grows with inflation. On Jan. 1, 2019  the annual contribution room increased to $6,000. Someone who has never contributed will have a cumulative contribution room of $63,500 in 2019.

RRSP vs TFSA

Which one is better depends on your age and stage and investment goals. Either way, as we live longer and fewer among us can count on company pensions, personal saving has to fill the gap.

Every year  investors ask what they should put in? A recent Globe & Mail article argued that a prudent course is conservative investments to make the most of these tax energizers.

Here’s why: The Fraser Institute estimates says that the average Canadian pays 42.5% of income in taxes, so $1 earned is really only 62.5 cents in hand.

An RRSP lets the full $1 work for you, growing and compounding over a long period of  time.  Of course, you pay tax when you take the money out, but you have also benefited from a lot of growth over time.

So, if you lose money on an investment in an RRSP, you not only lose the capital, you also lose the compounding power because the sum is smaller.

The effect is similar with TFSAs.  You can withdraw money tax free from a TFSA and recontribute it in the next year. But if the investment inside shrinks, you withdraw less and can  recontribute less and so have less money to grow over time.