Sunday, November 15, 2009

Basics of TFSAs vs. RRSPs

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Many Canadians are confused about whether they should be saving money in Tax-Free Savings Accounts (TFSAs) or in RRSPs. In some situations this can be a complex question. Let’s look at the basic differences between TFSAs and RRSPs.

The TFSA is similar to an RRSP in that the income from investments within the account are tax-sheltered. The main differences are as follows.

1. TFSA contributions do not give you a tax deduction. RRSP contributions are deducted from your income to reduce taxes.

2. TFSA withdrawals are not taxed. With RRSPs, any withdrawal is treated as regular income and is taxed.

3. TFSA contribution room accumulates at $5000 per year. RRSP contribution room calculations are more complex.

4. Any amount withdrawn from a TFSA becomes new contribution room for the future. Regular withdrawals from an RRSP don’t increase future contribution room.

A natural question is should you contribute to an RRSP or a TFSA? The answer depends on your tax rates. If your tax rate when you contribute money is higher than it will be when you withdraw money, then an RRSP is better. If your tax rate when you contribute money is lower than it will be when you withdraw money, then the TFSA is better.

Both RRSPs and TFSAs are better than investing in a regular account where any gains are taxed. So, if you are able to save enough, contributing to both RRSPs and TFSAs is the best option over the long term. Not paying taxes each year on investment gains is a huge advantage of both types of accounts.

An interesting difference between RRSPs and TFSAs is the perception of how much money you have. If you are in a 50% tax bracket, you will only get to spend half the money in your RRSP. However, all of the money in a TFSA is yours to spend.

So, having $200,000 in an RRSP may feel better than having $150,000 in a TFSA, but it isn’t better (if you are in a 50% tax bracket). This psychological difference may make people happier with bigger dollar amounts in an RRSP even if they are better off with a TFSA.

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