When RRSPs are better than TFSAs

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Excerpted from Tax-Free Savings Accounts: How TFSAs Can Make You Rich, by Gordon Pape. Copyright Gordon Pape Enterprises Ltd., 2013. Reprinted by permission of Penguin Group (Canada), a division of Pearson Canada Inc.

When RRSPs Are Better

There are some situations in which an RRSP is a better option than a TFSA – in fact, it may be the only choice. One example is a child or teenager with earned income. You must be 18 or older to open a TFSA, but there is no age limit for RRSPs. As long as a person has earned income, that person can have an RRSP account.

Most people don't realize this, so they pass up opportunities to encourage their children to put some of their earnings, however modest they may be, into an RRSP. For example, my granddaughter had a job at Canada's Wonderland, an amusement park north of Toronto, during the summer when she was 16. Her wages were modest, but they qualified as earned income for RRSP purposes. She was too young to open a TFSA, but she could contribute 18 per cent of her earned income (the maximum allowed) to an RRSP. And she could defer claiming the tax deduction until she is working full-time and the deduction will be more worthwhile. Meanwhile, the money will be compounding inside her RRSP.

She earned about $2,800 over the summer. That allowed her to contribute $500 to an RRSP. At the time, she had 49 years before she would reach age 65. At an average annual growth rate of 5 per cent, that $500 would grow more than 10 times, to $5,460.67, at the end of that time. It's just one more example of the magic of compounding.

First-Time Home buyers

One of the most popular features of RRSPs is the Home Buyers' Plan (HBP). This program allows first-time home buyers to borrow up to $25,000 from an RRSP interest free and to pay the money back over 15 years. Hundreds of thousands of Canadians have made use of it since the plan was introduced in 1992, originally as a temporary measure to help a beleaguered housing market. Now aspiring homeowners face the dilemma of whether to use an RRSP or a TFSA as the savings vehicle for their down payment.

An RRSP allows you to reach your financial goal more quickly because you do not pay tax on RRSP contributions (you get an offsetting tax deduction) and your money therefore accumulates faster. Take a look at the following chart. It shows how much money would be accumulated in each plan based on $3,500 a year in before-tax income. I've assumed an annual rate of return of 5 per cent and for purposes of the TFSA contributions a marginal tax rate of 30 per cent on the $3,500.

Home Ownership Savings: RRSPs versus TFSAs
 

Year                                RRSP                              TFSA  

At the end of six years, you will have accumulated almost $25,000 in the RRSP and can take maximum advantage of the HBP. The value of the TFSA, however, is only $17,498 because you were only able to contribute $2,450 a year after tax. It will be an additional two years before the TFSA reaches the $25,000 level, by which time you'll have your house. If you had to withdraw the money outright from the RRSP to buy the home, it would be a different story because the $25,000 would be taxed coming out. But with the HBP (as well as the Lifelong Learning Plan, which allows interest-free RRSP loans for continuing education), no tax is assessed on withdrawals as long as the loan is repaid on schedule or faster.

So, if saving for a first home is your number-one priority, the RRSP is the best way to do it. If you want to move even faster, use your RRSP refund to open a TFSA and save both ways.

Large Contributions

Because of the low contribution limits on TFSAs, big savers are better off using RRSPs because they can shelter more money from taxes. The maximum RRSP contribution for the 2013 tax year is $23,820, more than four times the amount you can put into a TFSA.

Of course, you're allowed to do both – the two types of plans can be used in tandem to build a supersized retirement nest egg.

ACTION SUMMARY

1. Contribute to an RRSP before a TFSA if you expect to be taxed at a lower rate after retirement. If your tax rate is likely to be higher than it is now, use the TFSA first.

2. If you are a member of a pension plan, contribute to TFSAs to supplement your retirement savings, especially if you have little or no RRSP room.

3. If you are planning to buy a house, save for your down payment in an RRSP rather than a TFSA and make use of the RRSP Home Buyers' Plan.

Excerpted from Tax-Free Savings Accounts: How TFSAs Can Make You Rich, by Gordon Pape. Copyright Gordon Pape Enterprises Ltd., 2013. Reprinted by permission of Penguin Group (Canada), a division of Pearson Canada Inc.