You can hit a nail with a monkey wrench, but that doesn’t mean it’s the best tool for the job.
There has been some excellent discussion of the new Tax-Free Savings Accounts (TFSAs) and how they compare to Registered Retirement Savings Plans (RRSPs), in particular relation to retirement income and tax efficiency (i.e.: in which account do you end up saving more). The simple answer is that it depends on what your tax rate is when you are putting money into the accounts versus your rate when you are taking it out in retirement.
However, I don’t think this is the right, or at least the only, way to look at these two options. Like the monkey wrench analogy above, the TFSA and the RRSP are two different tools, not designed or intended to do the same job. I recommend you seriously consider using both for the jobs for which they are built.
RRSP = Retirement
TFSA = Savings
The TFSA is a savings account. Yes, you can use it to save for retirement, but you can also use it to save for a house, for a car, or my personal favourite: for that unforeseen emergency that usually ends up on our credit cards or taking a chuck out of our RRSPs.
So how should you use your TFSA? If you regularly max out your RRSP and still have money left to invest, then it’s a ‘no-brainer’. Even if you are unable or choose not to use all your RRSP contribution room, the TFSA is a very smart choice to put (or start building) your 3-month emergency fund, savings for your children’s education (beyond the optimal RESP maximum), or any other financial goal more than one year in the future.
There are a number of downsides if you ever choose to take money out of your RRSP before retirement. Chief amoung them is the tax hit (your withdrawal is considered income), or at best you are locked in to a repayment schedule (as with the Home Buyer’s Plan). Neither of these apply to withdrawals from your TFSA, which makes it a far more efficient and flexible choice for any pre-retirement financial goals/needs.
To get your TFSA started quickly, there are a few easy strategies you could consider:
- Move your current emergency fund into a TFSA ($5,000 maximum this year).
- If you make bulk annual deposits into your RRSP, put 10-15% into a TFSA.
- Deposit your tax return in a TFSA.
- Start a $25/month automatic deposit.
My first recommendation to most people is to always have that 3-month (minimum) emergency fund in safe, liquid investments (such as a high-interest savings account, GIC, or bond/money-market fund). You want that money to be there if/when you need it. Beyond that, it is worth having a conversation with your advisor to help you determine an appropriate portfolio for your time horizon and risk tolerance. If it would help you keep your goals straight, you may even want to consider opening two different TFSA accounts; one for your emergency fund and the other for your savings (new home, renovations, car, big vacation, wedding, etc.)! Remember, you can still only contribute a maximum of $5,000 combined for the year (unused room does carry over).
Retirement planning with your TFSA is worth a article on it’s own, but suffice to say that the closer you get to retirement, the more you want to have built up in your TFSA. One big reason: income-tested benefits and clawback.