Which is Better for retirement savings – RRSP or TFSA?
Jeetendra Kumar, MBA (Finance), MA (Economics)
to a friend
Out of many options available to Canadians for retirement planning – most of us think about two main ones – RRSP and TFSA. The Registered Retirement Savings Plan (RRSP) has been the standard since 1957, when it was first established to encourage saving for retirement. Almost 60 years later (in 2009) a new retirement savings plan - the Tax-Free Savings Account (TFSA) - was introduced the federal government, providing Canadians with another powerful savings method. While the goal of both the RRSP and the TFSA is the same - to help Canadians save money - each is a unique savings vehicle with plan-specific advantages. This article will give a good solid understanding about what exactly they are
The Tax-Free Savings Account
Canadian residents who are 18 years or older can contribute up to $5,000 each year to a Tax-Free Savings Account. Contributions are not deductible for income tax purposes, but TFSA savings can be withdrawn tax-free at any time and for any reason. A TFSA can hold a variety of investment instruments, including cash, stocks, bonds and mutual funds, all of which can grow tax-free for life. That means that interest, dividends and capital gains earned in a TFSA are never taxed, even when they are withdrawn. Since the savings in a TFSA can be withdrawn at any time and for any reason, these plans are frequently used to save for purchases, such as automobiles, homes or even vacations. In addition, any money that is withdrawn can be put back into the plan in future years (but not during the same year if it would lead to over-contribution and a penalty tax).
The Registered Retirement Savings Plan
Canadian taxpayers each year can contribute up to 18 per cent of the previous year's earned income plus any unused contributions from previous years to a Registered Retirement Savings Plan - up to a yearly maximum contribution limit. The contribution limit for 2010, for example, is $22,000, and is set for each tax year. Contributions are tax deductible, and earnings grow tax-free inside the plan; however, withdrawals are taxed. Since withdrawals are typically made during retirement and when participants are earning less money, it is likely that lower-tax brackets will apply, resulting in less tax liability. Like TFSAs, RRSPs can hold a variety of assets including cash, guaranteed investment certificates (GICs), mutual funds, stocks and foreign currency.
Because RRSPs are tax-deferred savings vehicles, these plans are ideal for taxpayers who expect to have a higher tax rate when the money is put into the plan versus when they will take money out of the plan. Figure 1 shows a comparison of the basic features of the Tax-Free Savings Plan and the Registered Retirement Savings Plan.
Both RRSPs and TFSAs offer Canadians powerful means of saving for retirement. The Registered Retirement Savings Plan, which has been around for more than 50 years, provides an upfront tax incentive, since contributions are tax deductible. Withdrawals made during lower-earning years generally result in reduced tax liability. Tax-Free Savings Accounts, on the other hand, offer no upfront tax incentive, but since withdrawals can be made at any time tax-free, they provide a practical means of savings for retirement or even for large purchases. Canadians are not limited to choosing one plan over the other, and many opt for both plans to meet their savings and retirementgoals.