Friday, January 10, 2014

The difference between TFSAs and RRSPs

I recently gave a quick review of David Chilton's new book, 'The Wealthy Barber Returns'.  My recommendation for people struggling financially was summed up in three simple words, READ THE BOOK.

The lack of financial literacy in our society is mind blowing, with potential for serious ramifications down the road.  The time to become financially literate and to employ strategies to build savings is during our working years.  Obviously the sooner you start the better, but even if you only have ten or so years to go until retirement, there is still time to do something.  The alternative is to do nothing and to retire poor or keep working til they kick dirt on ya.

How illiterate are we?  Ask twenty people what the difference is between a TFSA (tax free savings account) and an RRSP (registered retirement savings plan) and I bet at least half won't have a clue.  People will know the ins and outs of the latest video gaming systems, the stats of every player on their favourite NHL team, who's sleeping with whom on a popular soap opera.  But the two biggest saving vehicles available to Canadians?  Huh???

A lot of good it'll do knowing Tyler Hall's plus/minus rating when you're too old to work and just barely scraping by.

RRSPs  have been around longer and are better understood, but still there are too many people who don't know the basics.  First of all many people put money into an RRSP because it reduces their taxes, resulting in a refund.  "I need to put some money into my RRSP so I can save on taxes and get a refund", some will say.  

Slow down just a second.  

Yes, RRSPs do provide tax savings in a fashion, but its more like tax borrowing. 

How's that?  

Well, eventually taxes will have to be paid on all the money in your RRSP, every dime....both the initial capital you put in AND on any growth.  So its not really tax saving, more like tax deferral.  Someone who put $5,000 into their RRSP every year for 10 years has to pay taxes on the $50,000 total that was sheltered in the RRSP, and if that amount grows to $100,000 in total ($50K invested + $50K growth), taxes will have to be paid on the full $100,000 once it is withdrawn.

Assuming a tax rate of 30% means that every year $5,000 was registered inside the RSP a tax savings of $1,500 was generated.  When the $100,000 is withdrawn, assuming the same 30% tax rate, $30,000 in taxes will have to be paid.  The government gives, then the government takes away, and more.  The gain, $20,000.  

A TFSA on the other hand offers no tax savings when the money is registered, but all the growth is tax free. So using our $5K per year for ten years example, with the money growing to an eventual $100,000 TFSAs will provide a full $50,000 net gain because as the name implies, TFSAs are 'Tax Free'.  Once the money is taken out there is zero tax hit, you get it all.

The TFSA came into being in 2008, and in my opinion it is the best thing the Harper government has done for Canadians during their tenure.  Just because RRSP has the word 'Retirement' in it, don't think that a TFSA doesn't have a role to play in retirement planning.  For those lucky enough to have a pension, a TFSA is a better option than an RRSP in most cases as I see it.

I'll have more to say on this in the weeks to come.  With demographic trends being what they are Canadians on average are getting older, and as recent polling suggests, we know its time to get our personal finances in order.  

Oh, and if you've forgotten already, pick up a copy of 'The Wealthy Barber Returns'.  


rww said...

You forgot to mention that the assumed tax benefit of an RRSP is the assumption you will be earning less at retirement and in a lower marginal tax rate and this pay less tax than you would if you paid it now.

But that is not always the case. You could end up paying more. But I suppose if you do you should be thankful to be in that position.

Marie Snyder said...

It's striking to me how many people don't understand basic finances - particularly dangerous for those who are struggling. I see this in my high-school classes when I ask university and college-bound about RESPs and many (and their parents) have never heard of them. For less than $50 a week, you can get an RESP for a kid and the government gives you an additional 20% FREE money!. Some people still think this is a scam - and I don't blame them - all things considered. It has no place in my course, but I make sure they're aware anyway. We need a mandatory course just on current financial literacy.