Boost your financial wellness with RRSPs and TFSAs

Registered Retirement Savings Plans (RRSPs) and Tax Free Savings Accounts (TFSAs) have a lot to offer when it comes to saving for your retirement or, in the case of TFSAs, any other savings goal. Just as regular exercise now will result in better health in your golden years, early and regular saving in RRSPs or TSFAs will pay off many times over if you give your investments time to mature. But to get the most out of your RRSP or TFSA, it’s important to know the benefits and drawbacks of each.

RRSPs

Benefits

As the name implies, an RRSP is a great way to save for your retirement, and one of the key reasons is that an RRSP lets you invest while sheltering your growth.

With non-RRSP investments, you pay tax twice over, first on your initial income and then on any income from your investments. When investing through an RRSP, by contrast, you get an income tax break first on the amount you invest, then on the RRSP investment income that remains in the RRSP. The idea is that when you do finally withdraw from your RRSP, you’ll be retired, and hence in a lower taxable income bracket. In the meantime, your gains are sheltered.

The added benefit of these RRSP tax breaks is that they allow your investments to compound faster than investments that are taxed, making it easier to achieve your retirement goal.

Also to your benefit, there are two instances where you can withdraw money early from an RRSP without incurring additional income tax. One is when you buy your first home. When buying your first home, you can withdraw up to $25,000 without penalty or tax, and you have up to 15 years to repay the amount borrowed from your RRSP. The same exception applies when withdrawing from an RRSP to pay for post-secondary education.

For all its advantages, however, there are also a few drawbacks to RRSPs. One can come when you need to withdraw your funds early.

When withdrawing from your RRSP, the withdrawn amount then becomes taxable income. If you’re withdrawing before retirement, this means you get taxed on your RRSP income at a higher rate than you would pay, presumably, if you’d waited until you retired. It can also mean getting bumped into a higher tax bracket. Basically, by withdrawing early, you lose the benefits you received from sheltering your income in the RRSP in the first place. Withdrawal fees also usually apply when withdrawing early from an RRSP.

It’s also important to keep in mind that some RRSP investment products come attached with withdrawal penalties or limitations. To avoid paying more than you bargained for or being locked out of funds you really need, make sure you know all of the facts when you make your RRSP investment choices. The best way to do this is to talk with a trusted financial advisor.

TFSAs

TFSAs are like RRSPs in that they act as a tool through which you can invest in various products, but with TFSAs, the income from those investments is completely tax-free. Unlike with an RRSP, you can withdraw the funds from your TFSA at any time, and the amount won’t be added to your income tax.

Beyond the income tax advantage, another benefit of the TFSA is that there are no fees at the branch level when you withdraw your funds, although some accounts, such as accounts with investment advisors, may still have fees.

One major disadvantage of investing in a TFSA instead of an RRSP is that you don’t receive any break on your income tax for the amount that you invest. For this reason, if you’re self-employed or someone who typically has an income tax bill at the end of the year—or if you’re investing for your retirement and just want to save on your income tax—an RRSP might be a better option.

Another disadvantage of the TFSA as a savings tool is, paradoxically, also one of its strengths: its flexibility. Unlike an RRSP, there are no restrictions when you withdraw from your TFSA investments unless otherwise stipulated by certain TFSA investment products. For this reason, some people treat TFSAs as they would a regular checking or savings account, depositing and withdrawing money throughout the year.

There are two reasons why this is problematic. Firstly, and most importantly, there are legal limits to how much you are allowed to contribute to a TFSA. The maximum contribution for 2013 is $5,500, and since unused contribution room accumulates, you could potentially contribute up to $25,500 if investing for the first time. When people use their TFSAs as they would a regular savings account, they can accidentally go over their legal limit, incurring financial penalties.

The ease with which you can take funds from your TFSA can also be problematic from a long-term savings perspective. Basically, it can be too easy to “borrow” funds from your long-term savings, making you lose the benefits of compound interest and potentially setting back your long-term savings goals. For this reason, the supposed drawback of an RRSP—the fees and tax penalties for early withdrawal—can actually make the RRSP more suited to long-term saving, preventing you from sacrificing the future for the present. Then again, if you’re likely to want or need access to your savings in the near term, the TFSA might be the better option.