RRSP or TFSA: which is better when you’re young?

He’s young, hip—and he has a TFSA

Baby boomers had just one option: the RRSP. But today’s savvy savers have a choice

When you started your first real job, along with the thrill of a regular paycheque came the little voice in your head (or maybe that was your parents’ voice) suggesting that rather than blowing your money on nights out, a new flat-screen TV or new clothes, you should probably invest some of your earnings in a way that could build your savings—not to mention provide tax breaks.

Your parents, many of them now retiring baby boomers, had just one option in their day: the Registered Retirement Savings Plan (RRSP). The mantra was to maximize their annual RRSP contributions. The value they built in their RRSP came through two principles: forced savings and the power of compounding.

Throw in the federal government’s tax sweetener of being able to apply your RRSP contribution against your income for a nice tax break and the results were, and are, significant. If you saved $5,000 per year starting at age 25, assuming an eight-per-cent average return on investments, your RRSP would be worth $1.3 million at age 65.

The RRSP still remains an excellent way to invest. It forces you to save and helps reduce your taxes. 
However, young people today have another investment tool, the Tax Free Savings Account (TFSA).  The TFSA was introduced in 2009, so it wasn’t available when baby boomers and their offspring were planning their retirement savings. As good as the RRSP has been for baby boomers, the TFSA could be the new basis for young investors’ retirement savings. You don’t need to have a lot of money and it’s a great way to get started now.

An RRSP and a TFSA are similar in that the investor does not pay taxes on returns earned inside the portfolios. So, money can compound more without the drag of taxes. The differences arise in the way you contribute and withdraw from these accounts. The RRSP limits how much you can contribute in any year, based primarily on how much total income you earned the year before. With the TFSA, there is a fixed limit each year (currently $5,500) regardless of your income.

An RRSP contribution is tax deductible on your annual tax return. A TFSA is not. However, if your tax rate remains unchanged throughout your life, an RRSP and TFSA will produce the same after-tax returns. In an RRSP, you are taxed at your marginal rate when you withdraw funds. The thinking is that by the time you must withdraw from your RRSP at age 71, your income will be lower than during your employment years and you will pay less tax. However, as many boomers are finding now, their tax rates have often remained the same in retirement. So while the RRSP has served as a tax deferral vehicle, it has not produced tax savings.  

With the TFSA, your contributions are not tax deductible but you pay no taxes when you withdrawal any of your original capital or the investment profits. You can also re-contribute the same amount you took out at any time after the year you withdrew the cash. Therefore, you can use your TFSA for many of life’s other expenses, not just retirement—like education, your first car, a down payment on a house, expenses related to starting a family, or anything that requires a lump-sum payment. This makes the TFSA a more flexible tax-sheltered savings account for younger people. As long as you are disciplined about replenishing your TFSA when you’re able, it will still continue to grow and be an important part of your retirement plan, along with your RRSP.

While both the RRSP and TFSA are good savings vehicles for retirement, young investors may want to consider first maximizing their TFSA each year because of the added flexibility and tax forgiveness on investment gains.

Michael Schaab is a portfolio manager in the Private Client and Foundation group at Leith Wheeler Investment Counsel Ltd. in Vancouver. This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. Taxation matters are complex and dependent on personal circumstances. Please consult your professional tax advisor.