Back in the day, I wrote why Warren Buffett would be a bad personal finance blogger. If I recall correctly, it was one of those posts that I thought would be important and go over well, but bombed with all of one comment. (Edit: nope, five! whole comments. Not bad) Not that the number of comments that a blog post gets is important, but still. I don’t think people got it.
I’ll save you the trouble of clicking back. Buffett would make a terrible personal finance blogger because he understands the value of compound interest so well. Instead of looking at a $5,000 vacation as “WHOO YOLO I DESERVE THIS,” the Oracle of Omaha would much rather defer that consumption forever, since all he’d see is the million bucks that $5,000 could become after ‘x’ number of years.
When it comes to TFSA vs. RRSP advice, many people are making the same mistake.
First, let’s review some of the relative basics. TFSAs are invested with after tax money, meaning the investor can put their $5,500 per year away and grow it inside their account tax free. The money can be taken out at any point without having to pay a penalty, which people obviously like.
Meanwhile, a RRSP is invested with pretax earnings. As an example, if you made $40,000 and contributed $5,000 into a RRSP, it would be like you only made $35,000. You’d get an increased tax refund for the $5,000 put away into the RRSP, meaning the next year you’d have approximately another $1,000 in more money from a bigger tax refund.
RRSPs aren’t flexible like TFSAs. They aren’t taxed while in a registered account, but can’t be withdrawn without a penalty either. Unless you’re withdrawing the money to put down on a house, you’re going to pay tax on it. And even then, you’ve only got 15 years to pay yourself back. And, of course, they’re fully taxable once you start taking out the cash. You can defer it to age 71, but after that yo ass is forced to take out that sweet retirement scratch, and pay tax on it too.
That last point is a big reason why I see all the people recommend the TFSA route over RRSPs. You can let those bad boys compound until you’re 187 (in theory, anyway, your organs may beg to differ), choosing to never withdraw. I always thought part of the the point of retirement savings was to spend the money at some point, but maybe I’m drunk.
But the fact remains that if you go that route, you’ll end up with less money. Because there’s less to compound in the first place.
I did a similar example the last time I wrote about this, but let’s assume we’ve got two people who make $60,000 per year, putting them in the 23% tax bracket. [Edit: it’s 22%. I wrote this on a Korean bus without internet access. But it doesn’t matter anyway] One contributes $5,500 to a TFSA, the other plunks down $5,500 into an RRSP. Let’s assume an 8% compounded return over time. After year one, here’s what it would look like:
RRSP investor: $5,940
TFSA investor: $5,940
Boy, that was anti-climatic, huh? You’ve come to the wrong place if you’re looking to get excited.
But what about year two? Remember, the RRSP investor is looking at a tax refund of 23% of $5,500, a whole $1,265. He goes ahead and reinvests that money onto the same RRSP, putting it and an additional $5,500 away. The TFSA investor puts in another $5,500. Here’s the results after year 2:
RRSP investor: $13,721
TFSA investor: $11,880
Even though this increased contribution effect would continue on as long as the RRSP investor continued to put money away, let’s stop after year 2. This will work well enough to get my point across. After 40 years of compounding, how big of a difference will it make?
RRSP investor: $548,840
TFSA investor: $475,200
All I needed to do was reinvest ONE RRSP tax refund to increase returns by about 15% over a 40 year compounding period. After five or ten years of doing the same thing the results will just be more striking. The RRSP investor will end up with a nest egg of hundreds of thousands more than the TFSA investor, all by taking advantage of the government’s generosity.
BUT WAIT, the TFSA folks are saying, Nelson forgot about taxes. Once he pays the MAXIMUM TAX BRACKET ON THAT RRSP, I’ll be the one laughing.
Which brings me to another really misunderstood aspect of RRSPs – the tax implications.
We’ve already established that most people don’t know a lick about taxes. They don’t seem to think tax brackets exist, and that if you’ve crept into the top bracket, then all your income is subject to the onerous tax rate. These people are more wrong than when you didn’t compliment your girlfriend’s new haircut.
You’re not forced to withdraw all that RRSP money at the same time. If you’re smart about it and take out about 7% of it per year starting at 65, you won’t end up paying much tax at all. A lot of it will already be liquidated by the age 71 deadline (when you’re forced to withdraw a certain percentage per year), and you’ll be in a low tax bracket because of the lack of employment income.
Even if you’ve done well outside of your RRSP and have income coming from either other investments or your TFSA, it’s easy to plan ahead of time with those. Maybe you sell those in your early 60s and move them into conservative instruments. Maybe you sell some losers in your non-registered portfolio during those years and defer the tax credits forward. Tax planning is a thing that isn’t really that complicated.
Or, if you’ve got so much money that you’re worried about paying all the taxes, maybe that’s a cue to retire early. There’s no rule that says you have to wait until you’re 65 to start withdrawing RRSP money.
And honestly, if you’ve been so successful that you’re stuck paying too much tax, I don’t have a lot of sympathy for your “plight.” Taxes are the cost of being successful. Absolutely take any legal opportunity you have to minimize your tax bill, but most folks won’t have that problem. They’re struggling to scratch out enough to put money away for retirement. Having the opposite problem is pretty much the epitome of a first world problem.
If you’re one of the lucky few that are able to max out both your RRSP and TFSA, it’s still wise to put money into the RRSP first. No matter what the tax bracket, reinvesting the tax refund will put you ahead. Besides, your retirement is a long way off. Who knows if the TFSA will even enjoy its tax free forever status in another 40 years.
As the old saying goes, a bird in the hand is worth two in the bush. The bigger tax refund you get from contributing to your RRSP is the bird in your hand. Use it. Warren Buffett would be proud.