TFSA vs RRSP priority for young couple

[Szarky]

Just when I thought I had it all figured out :confused:

I'm making the switch this week for both my partners and my RRSP's out of our institutions high MER mutual funds (mine is the worst with a 2.72% MER @ Investors Group, ouch!). After lots and lots of reading on these and other forums I figured I'll make the switch to TD eFunds. I thought I had it all figured out and then I ran into this new guy on the block... TFSA.

We're both in our mid 20's. Each have incomes around the 50k level. We each have about 10k in RRSP's. We never max. out our RRSP contribution room and I don't think we ever will in the future.

What priority should we have for TFSA vs RRSP? Let's keep this strictly about retirement savings. I know the TFSA has the benefit of being able to take out the money at anytime but I don't want to do that. I keep reading it all depends what tax bracket you'll be taking the money out at. Well I'm a looooong time away from retirement. I have no idea what I'm going to be doing in 30 years. Maybe I'll be making more money, maybe I'll be making less money.

Would it be safe for now to just focus on 100% RRSP with tax returns going back into the RRSP's. Or should I start thinking about putting a bit of money towards a TFSA. Right now we're doing bi-weekly contributions towards only RRSP's.

[Jucius Maximus]

If I was in your shoes, I would focus on TFSA before RRSP. This is because your income will probably go up, so you will have lots of money and contribution room ready to throw onto your RRSP in 20 years from now when you are in much higher tax brackets.

The other advantage of the TFSA is that since the growth is not taxable, you are protected from other new and higher taxes that may exist in 20-30 years from now and bite you when you withdraw your RRSP.

[simms]

http://taxtips.ca/calculators/tfsavsrrspcalculator.htm

have fun!

[Szarky]

If I was in your shoes, I would focus on TFSA before RRSP. This is because your income will probably go up, so you will have lots of money and contribution room ready to throw onto your RRSP in 20 years from now when you are in much higher tax brackets.

The other advantage of the TFSA is that since the growth is not taxable, you are protected from other new and higher taxes that may exist in 20-30 years from now and bite you when you withdraw your RRSP.

"Using the information below, RRSPs are better than TFSAs." Well that's what I got. There's way too many variables in that calculator though that could change over time since we're so young.

[simms]

"Using the information below, RRSPs are better than TFSAs." Well that's what I got. There's way too many variables in that calculator though that could change over time since we're so young.

It's a much better tool that's more accurate. It's better than a general statement that we can post here.

Put in your best guess as to the other variables. Otherwise we're just making general comments about which one is better, whereas the tool uses your numbers and estimates to make a decision right for you.

[john29]

If I was in your shoes, I would focus on TFSA before RRSP. This is because your income will probably go up, so you will have lots of money and contribution room ready to throw onto your RRSP in 20 years from now when you are in much higher tax brackets.

The other advantage of the TFSA is that since the growth is not taxable, you are protected from other new and higher taxes that may exist in 20-30 years from now and bite you when you withdraw your RRSP.

I would agree with this. Make RRSP contributions when your in higher tax brackets, TFSA contributions now. I like the TFSA is better because your gains inside are not taxable.

[damnos]

TFSA is great to keep emergency funds that you can access anytime - if you havent put some money aside to weather "bad times" you might want to use it.

BUT, a good strategy is to max out RRSP first and then use the tax refunds to fund your TFSA.
It's reasonable to think to contribute to RRSP when you are in higher bracket, but you also have to consider time-value of money, hence getting the refund now *might* be better than later.

[GemInite]

Unless you're really into investing taking advantage of TFSA probably doesn't benefit you as much at this time.

My TFSA right now is just a savings account and I'm making 1.05% interest. However I need that $ liquid because I'm getting married soon.

Also don't forget about compound interest with RRSP's. Everyone knows it's much better if you start early.

I put most of my money into my RRSP's at the start. Now that I'm looking to buy a home I can take out $25K as part of the Home Buyers Plan.

Also in regards to Investors group be aware if you've been with them for less than 7 years you will be charged DSC's to get out. I just learned this myself.

[wesboag]

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Also in regards to Investors group be aware if you've been with them for less than 7 years you will be charged DSC's to get out. I just learned this myself.

Yes if they are in series A, no if they are in series B.

DSC are not specific to IG. It is an industry wide commonality.

[Just Confused]

There are 2 reasons why a TFSA is better than an RRSP.

i) An RRSP is a tax deferral scheme. You will eventually have to pay that tax. In other words you can avoid paying tax today but it is based on the assumption that the government won't change the rules, or tax rates won't go up. If you are confident in those two things, you're more trusting than me. On the other hand a tax free savings account eliminates the tax in the year it is earned and you have no further obligations attached to TFSA earnings.

ii) The basic concept is that you will be earning less in retirement than you are now so the tax rate by extension will be lower. If you are planning to be poor in retirment that's OK for you, but personally I plan to be making more money every year and retirement will be my highest revenue years.

[Icedawn]

There are 2 reasons why a TFSA is better than an RRSP.

i) An RRSP is a tax deferral scheme. You will eventually have to pay that tax. In other words you can avoid paying tax today but it is based on the assumption that the government won't change the rules, or tax rates won't go up. If you are confident in those two things, you're more trusting than me. On the other hand a tax free savings account eliminates the tax in the year it is earned and you have no further obligations attached to TFSA earnings.

ii) The basic concept is that you will be earning less in retirement than you are now so the tax rate by extension will be lower. If you are planning to be poor in retirment that's OK for you, but personally I plan to be making more money every year and retirement will be my highest revenue years.

Just to provide a counterpoint -

i) The rules can change for both the RRSP and the TFSA, so it's not entirely accurate to suggest that TFSA earnings will be necessarily free from encumbrances.

ii) For almost all people, it's unlikely that they'll earn more in retirement than during their working/asset accumulation years. Even you want to have a higher standard of living in your retirement, it's entirely possible to achieve this while having a lower income, particularly because your need to save will be significantly reduced. If you don't have a mortgage or the need to save for retirement anymore, it's very easy to live as well as you do now on far less than your current income.

[simms]

Just to provide a counterpoint -

i) The rules can change for both the RRSP and the TFSA, so it's not entirely accurate to suggest that TFSA earnings will be necessarily free from encumbrances.

ii) For almost all people, it's unlikely that they'll earn more in retirement than during their working/asset accumulation years. Even you want to have a higher standard of living in your retirement, it's entirely possible to achieve this while having a lower income, particularly because your need to save will be significantly reduced. If you don't have a mortgage or the need to save for retirement anymore, it's very easy to live as well as you do now on far less than your current income.
And just to throw a wrench in it, your RRSP room is much harder to max out. At $5k a year the TFSA is somewhat limited.

[Sanchez]

There are 2 reasons why a TFSA is better than an RRSP.

i) An RRSP is a tax deferral scheme. You will eventually have to pay that tax. In other words you can avoid paying tax today but it is based on the assumption that the government won't change the rules, or tax rates won't go up. If you are confident in those two things, you're more trusting than me. On the other hand a tax free savings account eliminates the tax in the year it is earned and you have no further obligations attached to TFSA earnings.



This is a bit deceptive. There are two types of tax you need to care about - the tax on the income you received (e.g., from employment) that generated the capital you want to invest, as well as the tax on your eventual investment gains.

The elimination of tax you mention for the TFSA applies only to the second tax. The RRSP, however, defers both the income tax and the gain on tax. This means that you can effectively invest pre-tax money in the RRSP case, while for the TFSA you have to invest post-tax money. For someone in a high bracket (43%) this means you get a 75% bonus to your RRSP capital.

In any case, the relative value of the RRSP and TFSA have a simple mathematical relationship given the rates on contribution and withdrawal - it is easy to show that they are equivalent in the case of equal contribution and withdrawal rates (but see also the caveat I discuss next).

ii) The basic concept is that you will be earning less in retirement than you are now so the tax rate by extension will be lower. If you are planning to be poor in retirment that's OK for you, but personally I plan to be making more money every year and retirement will be my highest revenue years.

Earning less in retirement doesn't in any way mean you'll be poor. For one, even if you have identical expenses in retirement - you don't need as much gross income or withdrawal since you aren't saving for retirement any more.

The vast majority of studies show that you don't have the same expenses in retirement either - the true expenses are often 50-60% of your working year averages. Reasons include the disappearance of work-related expenses, a paid off home, and so on.

Even if you save a very high percentage of your income, which would - in theory - result in a high retirement income relative to your working income, most people would simply retire earlier, rather than have a massive retirement income. For example, if I make 100k a year, and can save 50k, I could certainly wait until 65 to retire with an income of 300,000 a year or something - most likely, however, I would retire when my theoretical retirement income was close to what I was spending currently, unless I enjoyed my work more than my free time.

Finally, there is an important distinction between the income years MTR and the retirement MTR that is often missed. While working, your MTR is basically set by your income - you make a certain amount of money, and other decisions, such as investing in a taxable GIC, making an RRSP contribution, working extra hours, whatever, come on top of that base income, generally at the marginal rate (unless they are so large to move you up or down a bracket).

During retirement, however, you are no longer working. So your base level of taxable income is quite low, unless you have a pension. You decide how much taxable income you will have by virtue of your earlier allocation between RRSPs and other accounts. This means that the comparison of working and retirement MTRs is misleading. You might say "Oh, I make 50k today, but I expect to have an income (spending is a better word, though) of 70k in retirement, so my retirement MTR will be higher" - but that 70k doesn't necessarily come as income. If you took it all from a TFSA, there would be no income at all, and if you are drawing down capital or receiving income at capital gains or dividend rates you'll have a much reduced taxable income compared to actual income.

In this scenario, the first $1 you contribute to an RRSP in your working years is going to be much better than your TFSA contributions, since you'll get a full refund on it (50k bracket), and you'll withdraw it nearly tax-free in retirement - since you have very little taxable income (even though your "spending level" is 70k). So nearly everyone - even those who expect to withdraw more in retirement than they earn today - should contribute at least something to an RRSP, since the initial contribution have this very desirable tax arbitrage. A good rule is that you should contribute at least enough such that your tax bracket (defined by taxable income - not total income or spending) is the same in retirement as in your earning years.

The analysis is interesting because it shows that contributing to an RRSP actually makes further contributions less valuable (since they are now more likely to come out at a higher rate). This negative fedback loop means that the optimal answer for some people will actually be a "mix" - usually answers such as "do some of A, and some of B" are weak answers following from laziness, insufficient analysis or risk aversion, but in this case it is actually mathematically correct in nominal terms.

[Just Confused]

This is a bit deceptive.

Good rebuttal.

I will fall back on the point that you are technically correct in the things you say but in practicality the outcome is different.

For someone in a high bracket (43%) this means you get a 75% bonus to your RRSP capital.

In my anecdotal observations, I find most people with whom I speak are not re-investing it in their RRSP or making use of that bonus in recognition that it is a refund of a future liability. They fritter it away on consumption and do not view it as a temporary loan from the taxman with which they can invest & earn a compounded growth on the spread. When you think of it , even paying down a mortgage with it is not effectively investing it for growth. You're simply improving the current cash flow situation by reducing the amount of principal/interest you're paying on that presumably appreciating asset. That infers part of the value of your home will be available in the future to pay that future tax liability. Personally, in my mind, my home is separate from investments. I don't want to borrow against it or sell it to pay a tax liability.

Maybe we're debating "How many angels can dance on the head of a pin?" because the scary truth is the median RRSP for a typical Canadian is not a pretty number. A quick search turned up this article (http://www.statcan.gc.ca/pub/75-001-x/2008102/article/10520-eng.htm#a1) dated early this year based on data from 2005-06. I couldn't find anything more current.

[sjweyman]

This has been discussed a lot, but it is best to keep it simple. The RRSP is only better than the TFSA if your tax bracket will be lower when you withdraw the money than when you contribute it.

If you assume 100% reinvestment of all contributions to your RRSP and ignore the time it takes to get your refund from the government, then the TFSA and RRSP are IDENTICAL if your tax bracket remains constant.

You can always contribute to the RRSP later in life when your income is likely to be higher anyway, so you might as well just max out the more flexible and user-friendly TFSA first. Simple as that really.

[Szarky]

Also in regards to Investors group be aware if you've been with them for less than 7 years you will be charged DSC's to get out. I just learned this myself.

I know :mad:

I hate IG :evil:

I was considering leaving my money with them for a few years so that the DSC's would be a lot lower since the % goes down every year but I just want to cut myself off from them and move on.

[Szarky]

Thanks for everyone's input. Tough decision here. Might just keep going with RRSP's and then reassess in a few years.

What really amazes me is the divide between everyone on this topic. Between here and where I posted the same question on canadianmoneyforum.com I'd say it's at about a 50/50 split for people favoring RRSP vs TFSA for my situation.

I played around with that calculator some more and I couldn't ever get TFSA to beat out RRSP. I played with the numbers within reason but almost always RRSP came out on top. I think on a rare occasion it said RRSP and TFSA was equal.

[simms]

Thanks for everyone's input. Tough decision here. Might just keep going with RRSP's and then reassess in a few years.

What really amazes me is the divide between everyone on this topic. Between here and where I posted the same question on canadianmoneyforum.com I'd say it's at about a 50/50 split for people favoring RRSP vs TFSA for my situation.

I played around with that calculator some more and I couldn't ever get TFSA to beat out RRSP. I played with the numbers within reason but almost always RRSP came out on top. I think on a rare occasion it said RRSP and TFSA was equal.

Perhaps it's because you're making more money now than relative to when you retire. That makes sense.