For Canadian investors the February 29th deadline to contribute to an RRSP is approaching. The question on many minds is whether the contribution should be to the RRSP (Registered Retirement Savings Plan) or its much younger and less understood relative the TFSA (Tax Free Savings Account).
If you can max out your contribution to both then great. If not, then you have a choice to make. What’s really important is to not overthink it. Both accounts have excellent benefits. But they do work very differently and these differences can determine which account provides the best benefits for each type of investor or investment.
From a tax perspective, the RRSP is a tax deferred account which means that you delay paying tax on any contributions or returns until the time that you make a withdrawal. Put simply, you avoid tax today and pay it in the future.
The TFSA is a tax-free account which works the opposite way. You contribute money that you have already paid tax on but any return or withdrawals from the account are forever tax free. Essentially, you pay the tax today but avoid it in the future.
The best option from a tax perspective depends mostly on how your tax rate changes in the future. A higher tax rate in the future makes the TFSA more attractive because you are avoiding future tax. A lower rate in the future makes the RRSP more attractive because that’s when you’re getting taxed. The tax rate staying the same would make them about equal.
But trying to predict your future tax rate is probably overthinking it.
One thing to consider is that with an RRSP any withdrawals are treated as regular income which means that you don’t get capital gains tax treatment for any share price growth. This can make a big difference if you’re a growth investor with you potentially paying up to 2 times the tax.
As a general rule, the TFSA is a better vehicle for growth-oriented investments with better capital appreciation potential and the RRSP as more of a long-term vehicle for investments where most of the return will come from interest and dividends.
The TFSA does have the added advantage of flexibility. You can move money in and out with less restrictions compared to the RRSP and there is no annual deadline for when you can contribute.
The answer of which is better (the RRSP or TFSA) depends on you. TFSA is an excellent choice if you are a more growth-oriented investors or you might have a need to move money in and out of the account over the years. The RRSP is an excellent choice for more income-focused investors that don’t have a need for the extra flexibility that the TFSA provides. Of course, for many people there is always the option of building up capital in both accounts over time even if you don’t max out your contributions every year.
The next step (and crucially more important) is decided specifically what investments to put into your accounts. Last year, KeyStone Financial put on one of our cross country, DIY Investing Seminars specifically on investing in RRSPs and TFSAs and how to build a profitable, 10 to 12 stock portfolio.
KeyStone has Spring 2019 dates set for our next DIY Stock Investment Seminar – Learn How to Create a Simple 10-20 Stock Portfolio.