As humans, we like to analyze things and I’m assuming that’s why there are some many dating sites yet fewer marriages actually occurring today. And while analyzing and debating an issue can be a healthy process to ensure we make the right decision, there comes a point when analysis leads to paralysis. Enter the RRSP vs TFSA debate. I hear this debate from friends and family and while I understand their intention sadly the debate always seems to end off where it started; debating the issue to feel as though they are acting rather than actually acting.
For the most part TFSA and RRSP share a lot similarities with a few small but major differences. Perhaps the biggest reason for this debate is TFSA carries a buzz word within its name that most people have strong feelings towards, taxes! That word has created a lot of confusion and miss information. But I will try my best to clear up some of the confusion around these accounts.
In the most basic and simple terms, the major difference between an RRSP and TFSA account comes down to the accounts tax treatment regarding withdrawals and contributions. RRSP contribution limits are determined based on previous year earned income or RRSP dollar limit set for the year, while TFSA contribution limits are set by the federal government each year and indexed to inflation.
When an individual contributes money into their RRSP account the contribution is taxed deductible against their current year income, which reduces their overall income earned and in turn results in them paying taxes on a lower reported income, which saves them taxes. TFSA contributions are not tax deductible against an individual’s income as the income has already been taxed and when you contribute to your TFSA the government doesn’t allow you to further reduce your taxable income like the RRSP contribution.
Both accounts contributions can grow tax free and by that I mean any interest, capital gain, or dividend earned from the money you contributed are not taxed while within a TFSA or RRSP. But the major difference that causes all the uproar and confusion is due to what happens when you decide to pull money out of the accounts. When you decided to pull funds from an RRSP before or when you’re retired you could be hit with a withholding tax anywhere from 10%-30% based on the amount you’re taking out and the amount pulled is then declared as additional income in the year you’ve pulled the money.
The contributions made to a TFSA and the associated interest, capital gain, or dividend earned through the years can be pulled at any time and you do not have to pay taxes on any of the money pulled. Makes sense since you were already taxed on the money and never got a refund to further reduce you’re income.
And there is where all the debate comes from. So as the debate goes, if you contribute money into your RRSP you get a refund today but when you’re retired and start pulling money from your RRSP account (likely a RRIF at that point) you pay taxes. As I said, people hate taxes. So while a refund was provided to help grow the money further, most people much like me likely spent their refund on a brand new TV. Naturally, upon retirement we get upset because paying taxes sucks regardless of the amount or type of account. But let me remind you why the RRSP was even created in the first place.
RRSP account was created with the idea that most of us will have a lower income in retirement than during our working years. If your making $80K during your working years, chances are you’re not making $100K during retirement, at least that’s the thinking. They were set up with the idea for individuals to grow their money tax free during their working years and when they retired they would be in a lower tax bracket and funds pulled would be taxed at lower tax bracket compared to their working years.
But who I’m I kidding, you just want to know which account is the better option. So with that in mind, I will give into your request and provide a general consideration you should be mindful of. Everyone’s situation is different and while I provide this general rule that doesn’t mean it will be true all the time or for you.
If you currently earn a high middle class income of let’s just say $80K (just making a number here) and say in retirement your expect your income will be say around $50K or at least much lower than the 80K you currently earn, the RRSP route is usually a better option. If you currently earn above average income say $100K (making up a number again) and in retirement you expect your income to hold steady at $100K or higher then generally TFSA is usually a better options since your tax rate will remain the same or perhaps higher in retirement. If your making say $50K and you expect your income to stay the same or much lower, it could be a toss up as to which option might be better.
Since I gave into your need for simple answers to complex questions I must end on a warning note. The difficulty in knowing which account is right comes down to the fact we can’t predict the future. Most of us have a hard enough time knowing where we might be in two years, so trying to predict your retirement income 30 years from now is nearly impossible. Secondly, I have these conversations over and over with friends and at the end I ask one simple question. How much have they contributed to either of the accounts? The answer is either none or a small contribution less than $2000 per year to either one. While they lack the resources to maximize either plans maximum contribution limit they believe debating is the same thing as acting. Its not!
Do yourself a favor and just do something and stop with the pointless debate that prevents you from actually acting. Both a great options and if your situations becomes complex or you actually have more money than your contribution room available seek professional help to break down the numbers for you. Stop analysis paralysis regarding RRSP vs TFSA and just do one of the options already!