There's a lot to love about TFSAs for a young investor.
So much of investing and saving involves rules, conditions and a natural bias toward big money. Tax-free savings accounts are simple to use and friendly to people who are just starting out as savers and investors.
TFSAs are a great place to save for future expenses, such as a car, wedding or house down payment, and they're ideal for building a portfolio of stocks, exchange-traded funds or mutual funds. But if your specific goal is to save for retirement, TFSAs have to be carefully compared with registered retirement savings plans.
The Globe and Mail's Gen Y Guide to TFSAs versus RRSPs is designed help in this analysis. You'll find four ways to consider these two approaches to retirement saving.
Human behaviour
Bruce Sellery, author of The Moolala Guide to Rockin' Your RRSP, is adamant that RRSPs are Gen Y's better choice for retirement saving. "For most people, regardless of age, that's the vehicle for retirement saving – period, full stop."
Mr. Sellery recognizes that there are situations where RRSPs are not a good choice, one of them being for people who have a low income and expect that to continue through retirement. Another is in the case of young adults who are just starting their careers and are in a much lower tax bracket than they will be later in life (more on that shortly).
"Everyone else should be in an RRSP," he said. "This is not a discussion. The TFSA was not designed for retirement saving."
TFSA's weakness as a retirement vehicle is that it's too easy to withdraw money, Mr. Sellery said. He acknowledges that money can be withdrawn from an RRSP, but there's a small amount of paperwork and a withholding tax to be paid. TFSA money can be withdrawn simply by making a banking or investing transaction. "The TFSA is like a little bank account. People get tempted."
Mr. Sellery noted the two official ways to withdraw money from RRSPs – through the Home Buyers' Plan (for buying a first home) and Lifelong Learning Plan (to pay for full-time education or training). He believes that both continuing education and home buying are legitimate reasons to withdraw money from an RRSP, "although I have a bigger question about whether young people should buy real estate."
Conclusion: From a human nature perspective, RRSPs are a better choice in that they make it tougher to raid your retirement savings.
The tax perspective
"We like to say do both the RRSP and TFSA," said Wilmot George, director of tax and estate planning at Mackenzie Investments. "But for an individual who is just starting out, very often the TFSA is the way to go."
It all comes down to your tax rate. As a young adult just starting out in the work force, you'll likely have a lower salary than you will later and thus you'll have a low tax rate. Mr. George said this is a perfect time to use a TFSA, which you contribute to with after-tax dollars. Once you've put money in a TFSA, you no longer have to worry about taxes on investment gains or on money you withdraw.
Mr. George said that later on, when your salary and tax rate move higher, it makes sense to use an RRSP. With an RRSP, you contribute after-tax dollars and then get the tax refunded to you. The more you pay in tax, the bigger the bang you get from making an RRSP contribution.
Money in an RRSP – or, after age 71, a registered retirement income fund (RRIF) – is taxed when you make a withdrawal. Mr. George said RRSPs work best when your tax rate in retirement is lower or the same as it was at the time you contributed money to your plan.
Conclusion: Many young people will find TFSAs a more tax-efficient retirement savings vehicle than an RRSP.
Your savings capability
The annual limit for TFSAs is $5,500 for 2014, and there's a cumulative $25,500 in contribution room for past years if you have never used one of these accounts before. For young adults and those who don't have much to save because they have young children, TFSAs offer ample savings room.
RRSPs allow you to contribute 18 per cent of your eligible income from the previous year, with a maximum for 2014 of $24,270 (that's up from $23,820 for 2013). Given the much larger contribution room they offer, RRSPs have to be considered for higher income people who want to save aggressively for retirement. Note: As with TFSAs, RRSPs allow you to carry forward your unused contribution room.
Conclusion: TFSAs are a building block for retirement savings, but you may need to use RRSPs as well to make sure you have enough put away.
Fees
Online brokerages have been cautious about charging administrative or account maintenance fees on TFSAs, which have only been around since 2009 and, thus, often can be modest in size. RRSP fees are a different story, especially for the small accounts that Gen Y investors are likely to have.
Fees on small RRSP accounts may cost as much as $25 per quarter or $100 annually. If you want to withdraw a lump sum from your RRSP, expect to pay $50 or more, in addition to a withholding tax pegged to the amount you're taking out. Taxes don't apply to withdrawals under the Home Buyers' Plan, but some firms will apply withdrawal fees.
TFSAs usually have no administration fees, but a few online brokers charge for withdrawals. In a small TFSA, a $25 withdrawal fee can eat up a significant piece of your gains.
For both accounts, be sure you make the right choice of broker before you set up the account. Many will charge as much as $125 to $150 to transfer an RRSP or TFSA to another firm.
Conclusion: TFSA fees are lower than those for RRSPs, but you can still get burned if you transfer your account to another firm.
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Rob Carrick