1. They save you more money on taxes
The biggest difference between a TFSA and an RRSP is this:
- TFSA: you pay taxes on the money you contribute, but not on the money you withdraw
- RRSP: you don't pay taxes on the money you contribute, but you do pay taxes on the money you withdraw
This is a fairly subtle difference that can have enormous consequences.
Imagine a fictitious scenario where Canada charges a flat tax rate of 30% and you have $10,000 you want to invest for retirement:
- In an RRSP you would not pay tax on your investment when you contribute. After 30 years of 7% returns your $10,000 investment has grown to $76,123. Now that you're retired you withdraw this money and pay 30% in taxes, leaving you with $53,286.
- In a TFSA you have to pay 30% in taxes on your initial $10,000 so your initial deposit is just $7,000. After 30 years of 7% returns this has grown to $53,286. Since your money is in a TFSA you don't pay any taxes when you withdraw this money.
So what's the difference? In the end you have the same amount of money. The problem is that the scenario I presented is unrealistic. In reality Canada does not impose a flax tax of 30%. Taxes increase depending on your income. If you're making $30,000/year now but ultimately plan on withdrawing $50,000/year when you're retired, contributing to an RRSP is increasing your effective tax rate.
Generally it's better to contribute to a TFSA in your low earning years and it's better to contribute to an RRSP in your high earning years. This is because your income should, in general, increase every year until your retirement.
2. Your contribution limit increases regardless of income
Another great thing about TFSAs is that your contribution room increases every year, even if you didn't earn any income. You can also carry contribution room forward indefinitely. If you turned 18 before 2009 you have $57,500 in contribution room to use whenever you like. You can find a TFSA contribution room calculator here.
On the other hand, to contribute to an RRSP you need to earn income. Currently your contribution limit increases by 18% of your annual income, up to a limit of $25,370 per year. Your RRSP contribution limit can be carried forward until you're 71.
This difference makes TFSAs a great tool for young investors who haven't earned enough income to build a sizable amount of RRSP contribution room.
3. They are more liquid
One of the biggest benefits of TFSAs is that you can withdraw your investment tax-free at any time without losing contribution room. Granted the rules are a little weird: if your TFSA is maxed out and you withdraw $10,000 you won't be able to re-contribute that $10,000 until the next calendar year.
Conversely if you withdraw from an RRSP before retirement that contribution room is lost forever and you have to pay a withholding tax penalty. The exception here is if you are withdrawing in order to put a down payment on a house or for education.
4. You won't be tempted to misuse your tax return
So here's the scenario: you've diligently contributed to your RRSP all year and when your tax return finally arrives you have a check for $5,000. What do you do? Unless you have the discipline to reinvest all of that money in your RRSP you will not do as well had you just paid your taxes and contributed to your TFSA. Contributing to a TFSA keeps big cheques out of your hands, which removes the opportunity to misspend them.