For American readers - this article deals with Canadian retirement savings vehicles. The same broad principles apply to the Roth vs Traditional debate, but the specifics of tax law are, naturally, different.
This year, the government of Canada added a new type of savings account to the arsenal of ways to reduce - or at least manage - your taxes. The Tax Free Savings Account lets you deposit up to $5000 per year and enjoy the full benefits of your investment growth, no taxes to pay. Having more options is usually a good thing, and this is no exception, but there's a lot of confusion about whether this is a better or worse option than putting your savings in an RRSP. This being investing we're talking about, there's not going to be a right and wrong answer. It all depends on your situation. So with that, a summary below on how to choose.
How They're the Same
Mathematically, there is no difference between paying taxes now, and paying taxes later, provided tax rates stay the same. Proof? You've got $1000 available to save, out of the $40k-$80k you make in a year. For simplicity, we'll ignore provincial taxes, since they're different for everyone. So, if you contribute this to your RRSP, you can actually contribute $1282.05 without spending more money, because you'll receive a tax refund worth 22% of your contribution, worth $282.05. Put it in your TFSA and you've got $1000 saved.
30 years later, at an average of 8% investment return, your TFSA will be worth $10,935.73 and your RRSP will be worth $14,020.15. To withdraw money from your RRSP, you'll pay 22% tax, leaving you with - you guessed it - $10,935.73. (Actually, 72 cents due to a rounding error) What fun.
So right here we've actually identified your number one concern when picking between a TFSA and an RRSP. The first question to ask is Will my tax rate be higher or lower when I retire than it is now?. If you are just starting your career and are in the lowest tax bracket, it's probably reasonable to assume your tax rate will be higher when you retire, so you should focus on the TFSA. If you're middle aged, your wage increases are unlikely to substantially outstrip inflation, and most people plan their retirements only collecting a portion of their working income, so the RRSP is likely a better option. It's also important that if you choose to contribute to the RRSP, you're willing to make the larger contribution and spot the government three hundred bucks for a few months.
What makes the RRSP better
Regulatory Risk
Regulatory risk is the risk that the rules of the game will change. If you put your money in an RRSP you get your tax benefit now, so there's not much politicians can do to screw you out of it. With a TFSA, you are counting on withdrawals not being taxed at some point in the far future...for people in my age group, that's 30-40 years. It's easy to imagine a situation where it is politically advantageous to begin taxing TFSA withdrawals. Decades from now, some of these accounts will be quite valuable, and there's every chance that the perception of the general public will be that this is a tax break that scews its advantages towards to wealthy.
Employer Matching
For those of us who don't participate in pension plans, a lot of employers offer a contribution matching program for RRSPs. The value of the employer match is going to exceed any tax benefit either way, so take advantage of these programs before even considering the TFSA.
Instant Gratification
Receiving a tax credit this year can be an incentive to save more for retirement than you would knowing that you have to wait 30 years to reap the benefits of these savings. If your someone who will be motivated by this, it's worth considering the RRSP.
When Investments go Bad
With a TFSA, if you lose money on your investments, it's gone. You've gotten no benefit from it, and you can't write off the loss against other investments that have gone up. With the RRSP, all the money in your account has already been written off, so there's at least some tax benefit to your loss.
"Retirement Savings", not just "Savings"
A Tax Free Savings Account, as the name implies, isn't strictly speaking a retirement account. You can withdraw money from it whenever you want to, and there are no penalties. You even get extra contribution room so you can put it back later. So there is less psychological barrier to making withdrawals, and it will require some willpower to stick with it as a retirement plan. If you can't afford to fund the full $5000 as retirement savings, you may also put some money in for shorter term goals, such as a vacation, a house, or a new car. This may make it harder to differentiate what's for retirement and what's for today.
What makes the TFSA Better
Lower Retirement Income
Provided the rules don't change, withdrawing money from the TFSA is like taking it out of any ordinary savings account. It's not counted as income. This is advantageous when you get old because the government gives money old people who don't make much. Taking the same money out of an RRSP gives you taxable income, which counts against you for these means-tested benefits. Old Age Security is the big one, but many provincial governments also have means-tested drug benefits...some municipalities even offer breaks on property taxes for low-income seniors. Again, as these accounts become more valuable, there's every chance that the rules will change, but the best we can do is make decisions based on today's rules.
Flexibility in Retirement
When you turn 71, you're required to turn your RRSP into a RRIF, from which you must make a minimum withdrawal every year, and pay taxes on that withdrawal. At the younger end, it's about 5%, rising to 20% of the fund's value as you get older. This means that even if you don't need the money (or would be better off without out it due to means-tested benefits), you don't have a choice, you've still got to make the withdrawal. The TFSA gives you the flexibility to decide when you need the money, and how much.
Death
If you care about what happens to your money after you've moved on, the TFSA has some real advantages. Canada doesn't have an estate tax, but when you pass away, all your investments are deemed to be sold, and your RRSP cashed out. (Exception: you can pass on your RRSP to your spouse with no penalty...when they die it will be cashed out) Since most people who've been good about saving in life have a sizable RRSP and investment portfolio at the end of it, it's virtually a certainty that at death, you'll be charged the highest tax rate there is, and government will get a good chunk of your money, instead of your children or grandchildren. If you intend to leave your estate to charity, the offsetting tax credit will make eliminate this benefit.
Screw the Government!
Sure, you might end up with the same amount of money at the end of this, but the government doesn't. In my original example, if you use an RRSP you'll pay over $3000 in taxes on you $1000 investment, whereas with a TFSA, it's less than $300. It's not like the government is taking that extra $300 in revenue and investing it, they'll spend it all this year. This could also be considered a downside, since the RRSP option allows you to reduce the overall tax burden at no cost to yourself.
So, Which One
As I said at the beginning, there really isn't a right or wrong answer. A lot of it depends on your personal preference. The general guidelines that I would work with are as follows.
Use the RRSP if...
Your current tax bracket is at or above the tax bracket you expect to retire to. My thinking is that it's reasonable to expect to retire into the $40k-$80k tax bracket (22%) for most middle class people.
Use the TFSA if...
You expect your taxes in retirement to be higher than your taxes today.
Obviously, if you have enough money to fully fund both, you should do so. But since most of us don't have enough spare money to max out even one, there's a decision to make. For me, the advantages and disadvantages of the different accounts balance each other out, and the primary difference between the two remains whether I get the tax benefit today or many years from now.
