Holographic, eh?

In 2007, the world went boom. The real estate market in the US collapsed along with its banking system. In the wake of this was left the rest of the world. And Canada was no exception. This was also the year the Canadian government introduced to us the TFSA (tax free savings account). I’m not entirely sure if this was because of the economic collapse, but the timing would make it seem so. The concept is much like your RRSP in that it’s a tax sheltered environment for your investments. There are two key differences which I’m going to make crystal clear, helping you understand which is right for you.

They’re Both Good

Just to preface, you should strive to max out your contributions into both your TFSA and your RRSP. The more space that your money has to grow tax sheltered, the better. Tax sheltering means that the growth on your portfolio won’t be hacked away by taxes. Say, for example, you had $1000 in investments and last year you made a growth of 10%. That $100 would be taxed at your marginal tax rate. The TFSA and RRSP, however, would protect you from that tax. Now with the basics out of the way, let’s get on to the differences…

It’s All About Taxes

The difference between these two tools is the way the taxes affect them. On one hand with the RRSP, the government considers money that sits inside of it a tax deduction. In other words, they’ll consider it money that you didn’t use towards your income and will return the tax that they took off of your income when you make contributions. Something to know about the government isn’t “if” you’ll pay taxes… it’s when. So with an RRSP, you’ll be paying taxes on the day you take the money out.

TFSAs Are A Bit Different

In contrast to the RRSP, a TFSA is simply taxed differently. Although you’re not paying taxes on the growth of your investment, a TFSA isn’t considered a tax deduction. The government is basically saying that if you want to put money in your TFSA, it’s going to be out of your own pocket. So, the government already got their taxes on that dollar when it was taken off of your paycheque. That being the case, you won’t get dinged when you decide to take the money out.

Which One Works Best?

As I mentioned last week, if you’re not reinvesting the return you get on your taxes into your RRSP, the value of it is hugely reduced. Assuming that we’re all responsible investors, the answer to whether a TFSA or RRSP is better is that it depends. The deciding factor depends on your income.

Since the contribution room of a TFSA is a flat $5000 each year, there isn’t much of a variable there. With an RRSP however, your maximum contribution room is 18% of your income. As a general rule, I prefer to have my money in a TFSA, since I don’t pay taxes on the withdrawal. Ultimately, however, if you’re going to have a higher income later on in life, then max out your TFSA. With lower current income, you’ll have less RRSP contribution room today and you’ll be paying higher taxes when you take the money out later.

If you’re going to have lower income later on in life, then the exact opposite is true. Max out your RRSP today, since you have a bigger contribution room and this will reduce your income tax liability today. When it comes time to cash out, you’ll also pay less tax.

It’s easy to see why people don’t more carefully choose where to put their money. Both tools seem very similar and yet the difference in the end can be huge.