For many students and recent graduates, retirement is a distant prospect. There are student loans to pay, jobs to find, families to build and a million things between now and then.
But financial planners agree that it’s never too early to begin saving for retirement. Currently, there are two main approaches – a registered retirement savings plan (RRSP) and a tax-free savings account (TFSA). But what is the best choice?
REGISTERED RETIREMENT SAVINGS PLAN
An RRSP is a tax-sheltered account that allows holders to build their retirement savings while also getting a tax break on current income. Investment certificates can also be placed in this account.
At 2010 limits, individuals can contribute 18% of their income, to a maximum of $22,000, yearly to their RRSP, minus whatever they contribute to a registered pension plan. The percentage and cap can be changed by the government but has remained the same for several years.
Whatever is contributed annually to the account can be deducted from that year’s taxable income and any interest or income earned in the account is not taxed as it is earned.
If the account holder withdraws money from the RRSP, it is considered taxable income and is taxed at the account holder’s current tax rate. Additionally, withdrawals cannot be replaced in the RRSP until the following year.
TAX-FREE SAVINGS ACCOUNT
Contributions to a TFSA by contrast are made with after-tax dollars and offer no tax deduction for deposits.
Savers can contribute $5,000 every year in either general income or investments. The money will then earn interest, or if investments are placed in the account, dividend payments or capital gains, and that income is never taxed, which is what makes the TFSA a tax-sheltering account.
TFSA account holders can withdraw money from the account at any time without facing tax penalties, as they would with an RRSP. They can also return withdrawals to the TFSA.
SO WHICH IS BETTER?
RRSPs offer a higher capped contribution amount than TFSAs, allowing contributors to save more money on a yearly basis, but this may not be a negative aspect of the TFSA for lower income earners.
John Stipetic, a financial planner and Scotiabank branch manager at Carleton University, says a TFSA is a great option for students and recent grads since they are probably earning around $30,000 a year as a starting salary.
Stipetic says the account offers more flexibility for low-income earners, in the event that something happens and he or she needs access to the money.
“What we see in many cases is someone starts out with an RRSP with good intentions, and then life happens,” he says. “They end up needing the money to pay for furniture, buy a vehicle, etc. They want to take out the money.”
The goal of the RRSP is to leave the money untouched until retirement building the account annually. Early withdrawals mean an RRSP loses its value, Stipetic says.
TALE OF THE TAX
Angela Melhuish, a financial planner for Investors Group Financial Services in Ottawa, recommends TFSAs for lower earners as well, partially because an RRSP has fewer tax advantages.
“(RRSP tax deductions) are beneficial if you are in a high tax bracket or if you won’t be getting tax credits,” says Melhuish. “But as a student, you get a lot of tax credits.”
So lower income earners or students may gain more from a TFSA, she says, since most students don’t need an additional tax reduction. She, like Stipetic, says it’s also a more flexible option for students to consider.
But an RRSP could have advantages for a less disciplined person, says Julie Westall, a financial planner at Future Financial Planning Group in Ottawa. Spenders may be more likely to dip into their TFSA for frivolous purchases, she says, and could benefit from the restrictions placed on an RRSP.
“(With an RRSP), it’s harder to get your hands on the money,” Westall says.
Ideally, a lower income earner would split his or her contributions between an RRSP and a TFSA, but it really depends on each individual situation, she says.
All three financial planners recommend most clients look into a RRSP when they begin earning around $50,000 annually, but that decisions should be made on a case-by-case basis.
THE BOTTOM LINE
Both RRSPs and TFSAs are great options for saving money and avoiding or reducing taxes. But there are distinct advantages and disadvantages to each.
A TFSA is better for short term-savings for people just entering the work force, says Stipetic, while an RRSP is good for long-term growth. But an RRSP is not as liquid as a TFSA and is subject to withholding tax once the money is withdrawn.
Westall recommends that students sit down with a financial planner to consider their options before determining what is best for them.