Your retirement might be decades away, but you should know the difference between RRSPs and TFSAs.
February is the perfect time to start planning for the future. (This also makes tax season sound like it’s good for you.) The business pages are abuzz with their perennial debates about TFSAs and RRSPs—acronyms that supposedly hold the key to beach houses, chalets and, well, not retiring to the poorhouse. Here’s a brief guide to help you understand how the Registered Retirement Savings Plan and the Tax-Free Savings Account can lend a little magic to your future.
The RRSP allows you to sock away a set amount of money, tax-free—for now. This is useful if you’re in an income bracket where you pay a lot of tax, and you’d like to pay less. The money you put into your RRSP comes off your total income for the year and you pay tax on what remains. That means more money now, and more money for the future. The maximum contribution room for 2011 is $22,450, and, if you haven’t maxed out previous years’ limits, you’ve got even more room. (So if you want to make a massive RRSP contribution this year, you have until Feb. 29 to win the lottery.)
As the theory goes, by the time your golden years wheel around and you start pulling money out of your RRSP, you’ll be living on less. When the government comes to collect tax revenue on the income you’re skimming from your RRSP, you’ll be sitting wrinkled and pretty in a lower tax bracket, Margarita in hand, paying Big Brother a pittance.
So, that’s then, but this is now. Let’s assume you’re in your 20s or 30s and you’ve still got a few decades to pay into a balanced investment portfolio that, God willing, is going to grow. The RRSP is locked up so you can’t access it, and it provides a tax refund on the money you invest. Sounds like a wise investment option, right? Bestselling financial author and chartered accountant David Trahair says yes and no. He says it’s possible to start RRSP saving too early. Trahair argues that for those with lower incomes in low tax brackets, there’s little to gain from the RRSP because the tax incentive is lower.
He also castigates those who save for retirement by borrowing before they really have the money to save. A lot of people take out loans to max out their annual RRSP allotments, figuring that if the interest on their investments outstrips the interest on their loan, they cover their costs and still make money. Trahair calls this flirting with “personal financial demolition”; he loathes debt, and argues that if you’re holding any, “you’ve got bigger problems.” No saving, he recommends, until you’re firmly in the black. Trahair does point out that the RRSP can be used by first-time homebuyers to invest in a house. The Homebuyers’ Plan lets you borrow $25,000 from your RRSP, which sounds great—except that after a year of freedom and home ownership, you have to start paying the loan back. To yourself. You’re required to pay it all back within 15 years; keep in mind that on top of this, you also now have a mortgage.
So, if saving for a home is your first priority, and saving for the future is, for now, a distant second, Trahair has a better idea. The Tax-Free Savings Account, or TFSA, is like a Swiss bank account on Canadian soil—your personal tax shelter. You can invest up to $5,000 a year in the TFSA, and if you don’t make full use of that amount this year, what’s left rolls over into next year’s maximum. A first-time TFSA owner could invest up to $20,000 today, since the program’s currently in its fourth year. Unlike the RRSP, that money isn’t tax deductible, but it grows tax-free inside the TFSA. This means you’ll never pay tax on the interest you build, and when the perfect starter house comes your way, you can take money out of your TFSA without paying any kind of penalty.
Now, keep in mind that retirement will someday loom closer, so if you fear the possibility of blowing your savings on Sunwing trips to Cuba in the short term, it’s smart to start an RRSP that’ll keep your savings out of reach. But for those of us with smaller paychecks and the need for a little wiggle room in case of emergency, a TFSA is a rainy-day savings option that can really pay off.
Hilary Doyle is a broadcast journalist who wrote and starred in CTV and BNN’s financial comedy series Stock & Awe.