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Tina Di Vito, director of retirement strategies at Bank of Montreal. (Pawel Dwulit for The Globe and Mail/Pawel Dwulit for The Globe and Mail)
Tina Di Vito, director of retirement strategies at Bank of Montreal. (Pawel Dwulit for The Globe and Mail/Pawel Dwulit for The Globe and Mail)

TFSAs vs. RRSPs

TFSAs lag behind in the retirement race Add to ...

In the 55 years since registered retirement savings plans were created, they have become a staple of Canadians’ financial diets.

Thanks to decades of familiarity, RRSPs are only slightly more exotic than chequing accounts and mortgages. Most adults know that RRSPs are good for them, even if they don’t use them as much as they should.

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But the introduction of tax-free savings accounts three years ago has muddied the picture. Investors are confused about how TFSAs relate to RRSPs, and which one they should be using.

The basic answer is this: both. The advantage of using one more than the other depends largely on one’s income, but saving in either is better than saving in neither.

“In an environment where interest rates are as low as they are right now, making sure you’re tax-effective is a great way to increase your ultimate return on that investment,” says Mike Henry, senior vice-president of retail payments, deposits and lending at Bank of Nova Scotia.

Knowledge is the first step, but on this front Canadians appear to be falling short. A comparison of the number of Google searches for “RRSP” and “TFSA” over the last three years is telling, with the former vastly outnumbering the latter.

A recent Bank of Montreal survey suggests that 64 per cent of Canadians know about TFSAs and 69 per cent about RRSPs. But roughly 40 per cent of those surveyed didn’t know the differences between the two.

People stick with what’s familiar. A Scotiabank poll found that 48 per cent of Canadians have a TFSA, compared with 60 per cent for an RRSP. Average annual TFSA contributions are significantly smaller than RRSPs.

It’s possible that TFSAs are lagging because savers have done their homework and favour RRSPs. But the Google results suggest that’s unlikely. The only way for individual investors to know what’s right for them is to do their research, or visit a financial expert for advice.

Here are some of the basics.

The main difference is that an RRSP gives you an immediate tax refund and a TFSA doesn’t, said Howard Kabot, vice-president of financial planning at RBC Wealth Management.

Most of the tax savings from an RRSP stems from the assumption that you will be in a lower income tax bracket after you retire. Mr. Kabot offers this example: Say you live in Ontario and are in the province’s highest tax bracket, so your tax rate is 46 per cent. For every dollar you contribute to your RRSP, you receive a tax refund of 46 cents. If you wind up in a 30-per-cent tax bracket after retirement, you will pay 30 cents for each dollar you take out of your RRSP. So you’ve gained 16 cents.

While TFSAs offer no tax refund on contributions, you don’t have to pay tax on withdrawals, so your investment returns grow tax-free. Anyone who expects to be in a higher tax bracket in retirement than they are now will probably want to make more use of TFSAs.

Another big thing to consider is what type of social benefits you might be eligible to receive after retirement, such as Old Age Security. Many of these benefits are clawed back when you hit a certain income threshold. While RRSP withdrawals could potentially cause clawbacks, TFSA withdrawals won’t. So if you want to go on a big trip after retirement, you could safely take the money to pay for it out of your TFSA without interfering with your social benefits.

“If you’re a lower-income person, some of the math shows that a TFSA might be a better way to go,” says Mr. Kabot. “Because with the RRSP you’re not really benefitting as much from the changes in tax rates, and also Old Age Security is important and you don’t want that clawed back.”

Adults receive $5,000 of TFSA contribution room each year, regardless of their income. And if you take money out, you can put that amount back in. RRSP withdrawals, on the other hand, cannot be replaced – the investor must earn contribution room each year that’s dependent on their income level.

“A lot of people automatically think that they can’t make a TFSA contribution because they’re not working, which is not the case,” says Tina Di Vito, the head of BMO’s Retirement Institute and author of 52 Ways to Wreck Your Retirement ... And How to Rescue It.

Young people with little or no earnings won’t have much RRSP room, but if they have money to put away, it likely makes sense for them to look at TFSAs once they turn 18 (which is the minimum age to open one). “They don’t need the tax deduction, so there’s no loss there, and in fact as their career progresses and they earn more money and are in a higher tax bracket, they can take all of the money they had put in the TFSA, and even the growth on it, withdraw it at no tax impact and put it into their RRSP,” Ms. Di Vito says.

People who are already in their retirement years should know that while RRSP contributions must stop by the year you turn 71, you can keep contributing to a TFSA as long as you live.

Another thing to consider: Canadians are good at respecting their RRSPs as retirement savings. But that might not be the case for TFSAs. In fact, when Finance Minister Jim Flaherty first unveiled TFSAs he suggested that investors use them to save for things like cars and trips. “An RRSP is primarily intended for retirement, but the tax-free savings account is like an RRSP for everything else in your life,” he said at the time.

Indeed, TFSAs are great savings vehicles for the near term, as well as great tools for retirement. If your goal is to save for retirement, and you’re worried that you might be tempted to dip into your TFSA for another reason before you hit your golden years, then an RRSP might be a better way to go.

One idea might be to make your RRSP your primary retirement savings vehicle, and to put the RRSP tax refund you get each year into a TFSA that you can dip into if need be.

Many investors don’t realize that there is no difference in what you can hold inside of an RRSP and TFSA – everything from cash to stocks to mutual funds and government bonds are permitted in each.

Mr. Henry says now that TFSAs have been around for a couple of years he’s starting to see investors shift away from mostly deposit-like investments (high interest savings accounts, GICs), which might suggest that more people are thinking of their TFSAs as accounts for the long term, not the short term.

“Increasingly, especially for people who have had their TFSAs open for a couple of years, we’re starting to see more long-term, growth-oriented mutual funds edging in there, which is an indication that people are actually balancing out the use of the TFSA as part of their overall investment plan,” he says.

For tips, stories, videos and live chats ahead of this year's RRSP contribution deadline, check the Globe Investor 2012 RRSP season section for daily updates.

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