RRSP vs TFSA
What’s the Difference?
Today I am going to talk about RRSPs and TFSAs and what the difference between them is. I am not going to ever say which one is better, because each account has its own place and in some cases the RRSP is better and in others, the TFSA is better. Financial Planning is a personal process based on your circumstances and no one else, that’s why you should try to avoid just assuming one is better because some one said it was.
The only thing I will say is that everyone should utilize a TFSA and some people shouldn’t utilize an RRSP.
The first thing to understand about RRSPs and TFSAs is that they are just 2 different types of accounts with different rules. Simply put, they are just accounts that you can put money into and take money out of. They just have more rules than a typical savings or checking account, because they have different purposes.
They both have almost the exact same rules as to what you can do with your money once you have it in the account.
Inside of your RRSP and TFSA you can:
Keep your money in cash
Buy Mutual Funds
Buy and sell stocks
Buy Mortgage-backed securities
Buy Canadian Mortgages
Invest in Income Trusts
Own Gold and Silver Bars (this was news to me)
Things you can’t own:
Personal Property (art, cars, etc.)
Physical Real Estate
Shares in Private Companies
Commodity Futures Contracts
So, anyone that tells you that it’s impossible to make money in an RRSP or a TFSA, ask them if they think owning Apple Shares worth $10,000 in 1980 would have made money? Then say, I could have owned those in my RRSP and I’m pretty sure they have increased in value.
What is more likely is that the person you heard that from bought expensive investments and or made the same common mistakes that most investors make when they see bad performance. The returns have absolutely nothing to do with the RRSP or the TFSA, just the investor and the investments they bought.
Now, that’s always my favourite objection to RRSPs, because it couldn’t be further from the truth, so for the next part I am going to discuss the growth inside of the RRSP and the TFSA.
Most people don’t get to the stage where they have maxed out their RRSPs and TFSAs, so I think it’s why there is so much confusion.
Growth inside of an RRSP is tax-deferred and growth inside of a TFSA is TAX FREE, but all you need to know right now, is that if you owned the exact same investments inside of your RRSP and your TFSA, they would grow at the exact same rate and if you owned those exact same investments in what is called a Non-Registered account, then your returns would be lower due to tax. It’s that simple.
Why is tax-deferral a good thing?
So, let’s say that you don’t invest inside of an RRSP, or a TFSA and you instead invest all of your money in a non-registered account.
Now let’s say you have $100,000 invested and one year it makes 10%, or $10,000.
That money is now going to be taxable to you and to just makes things simple, let’s pretend your tax rate on that growth is 30%, so now you owe the government $3,000, so you’re left with $107,000 to invest the following year. This significantly reduces the power of your compound growth.
However, inside of the RRSP and the TFSA, you are never taxed on the growth, so your accounts will grow at a way faster rate.
So those are the similarities between the TFSA and the RRSP and now I will discuss the differences:
Your RRSP room grows every single year by 18% of what your income was, but it is capped at a maximum of $26,230/year.
So, if you made $100,000, your RRSP room would grow by $18,000 that year, but if you made over $146,000, your room won’t grow any higher than the maximum. This is to cap tax savings on the wealthy. There are ways to do things a little different if that’s an issue for you.
However, if you have a pension, your RRSP room is reduced due to a pension adjustment formula.
The whole point of an RRSP is to give Canadians incentive to build their own pension if they don’t have one, or add onto one you do.
Any room you don’t use carries forward to the next year and keeps adding up over time. All of these numbers can be found on your annual Notice of Assessment.
The TFSA doesn’t care how much money you made, just that you’re over 18. If you are over 18, then you got a new $6,000 worth of TFSA room this year on January 1st.
So, to make my life easier, I am going to look at someone who was over 18 in 2009 and you’ve never put any money inside of your TFSA, then you have $63,500 worth of room. This will go up by another $6,000 next year and so on. The reason why it went up to $6,000 this year instead of by $5,500 like last year is because whenever inflation on the limit goes up by $500, they increase the limit.
Now, the major and most confusing difference is putting money into these accounts and taking money out, so I am just going to use an example, because I like comparisons and stories.
Husband uses RRSP and Wife uses TFSA
You know I like examples, so here’s a 30-year old guy who makes $60,000 and his girlfriend (who will become his wife) makes $60,000 and he wants to save $5,000/year into his RRSP and she wants to save $5,000 per year into her TFSA.
He puts his $5,000 in and now he is going to get a tax-deduction for his contribution, so, over the course of the year, he made $60,000 and pre-paid the taxes on that income off of his cheques, but the contribution reduces his income on paper by $5,000 to $55,000, so now he has paid taxes like he earned $60,000 and paid too much. Therefore, he is entitled to a tax return and in his case, since that $5,000 chunk lands in the 30.5% tax bracket he will get $1,525 back.
$5,000 x 30.5% = $1,525
If you have no clue what I’m saying, watch my tax brackets video. https://youtu.be/o7b5dD9F0p4
He now gets $1,525 back and spends it all on his girlfriend, because he wants her to become his wife.
His girlfriend heard RRSPs are crap, so she puts her $5,000/year into her TFSA and nothing happens. She gets no tax return and the only thing that has happened is her room is reduced by $5,000, so she only has $58,500 now, but it’s ok, because she will never run out of room as her limit will go up by more than she is putting in every year.
A quick note. If she takes that $5,000 out, she will not get that room back until the following year. If you want to just learn about TFSAs, watch this: https://youtu.be/rtIQI57aUhk
So, now let’s compare. They are both 30 and they both invested $5,000/year. The boyfriend into his RRSP and the Girlfriend into her TFSA.
They bought the exact same portfolio on the same day and got a 5% return until they were 65.
Watch this video to see how much difference a little timing can make: https://youtu.be/-0zV80USibY
So, now they have both invested $175,000 and they both have $451,000 in their accounts. They have made $276,000
Remember, if they didn’t invest in the RRSP, or the TFSA their growth would be significantly smaller as they would have had to pay tax each year the account grew in value.
The only difference so far is that the boyfriend got a tax return of $1,525/year, which would total $53,375 in saved taxes over that 30-year period.
But now, here is the other big difference.
RRSP Withdrawals are FULLY TAXABLE and TFSA withdrawals are TAX FREE!!
The husband has to pay tax on all of the money he pulls out and the wife can pull out any amount she wants and never pay one cent in tax.
So, I think RRSPs get a bad wrap, because people get mad when they think they’re getting a $451,000 inheritance from their dad’s RRSP and then they see the tax bill, because if he sold it all in that one day, then his income for that year would be at least $451,000 and he would owe a crazy amount of tax. Up to like 50%, depending on where he lives, but pulling a lot of money at once is not even close to the point of an RRSP. It is meant to be a pension fund and there are other structures to put in place to maximize inheritances.
So, now he wants it to last until he is 90, so he pulls it out $26,000/year and assuming he gets CPP and OAS totalling $20,000/year, his income is $46,000, so his average tax rate that he pays on his withdrawals is 17.04% in Alberta. His RRSP withdrawal is taxed $4,430/year.
After tax on his $46,000 income, he has
$38,163* = ($46,000 - 17.04%)
· He has to pay tax on the CPP and OAS income too.
His wife withdraws the same amount, but only pays tax on her OAS and CPP, which equals an average rate of 6.69% in tax.
After tax on her $46,000/year, she has:
$44,663 ($46,000 - 6.69%)
She definitely has a higher income in retirement due to her lower tax bill, so it appears that she is the winner, but is she? I mean, she does have an extra $6,500/year that he doesn’t.
What about that $53,375 that he got back? Everyone always forgets about that don’t they? Most likely he spent all of that on crap he didn’t need and it didn’t cross his mind that he had an extra $53,375to spend in his life that his wife didn’t.
But, what if he was good at planning and instead, took his $1,525/year and built up his TFSA?
Now he has $138,000 in his TFSA and $451,000 in his RRSP.
So, now he can pull out $7,925/year TAX FREE out of his TFSA to add onto his after-tax income of $38,163.
He can now spend $46,088/year, which is $1,425/year higher than his wife. Had she done it too, they would have an extra income of $2,850/year for 25 years.
And that is the difference between RRSPs and TFSAs and that is how to use them perfectly to compliment one another if you’re not in a position to max them both out every year.
Feel free to comment or ask personal questions about your financial situation by contacting info@K4Financial.ca