TFSA vs. RRSP (for Canadians)

Tax Free Savings Accounts (TFSA) and Registered Retirement Savings Plans (RRSP) are tax efficient methods for Canadians to save prescribed amounts of money. Each method has it’s “contribution room” (how much one is allowed to put in per year) determined in a different way. Since everyone knows about RRSP’s, I will focus on explaining the less understood TFSA.

TFSA:

Starting in 2009 when the program was launched, every Canadian over the age of 18 is allowed $5000 of contribution room. It doesn’t matter if you make $100 of income during the year or $500,000. However, your unused contribution room accumulates and is carried forward if you do not use it in any given year! Another important point is that you are allowed to contribute to your spouse’s account. So if this is the first you’ve heard of this and you and your spouse haven't put anything into a TFSA yet, then you will each already have $15,000 of unused contribution room (from 2009, 2010 and 2011) that you can begin filling up immediately.

You can withdraw from your TFSA at any time for any purpose (but it takes a couple days to get the money out, so it's not as fast as a normal savings account) — and the full amount of withdrawals can be put back into your TFSA in future years. Re-contributing in the same year, however, may result in an over-contribution amount which would be subject to a penalty tax.

Trade-Off:

The basic trade-off between contributing to TFSA vs. RRSP is that contributions to an RRSP are deductible and reduce your income for tax purposes. TFSA savings contributions are not deductible, but any income/capital gains in your TFSA are NEVER taxed. Not when earned, not when withdrawn.
Conclusion:

Which method you want to contribute into first depends on your unique situation (which you should speak with your financial planner about). If you can, however, you should try to contribute the full amount possible to both accounts each year. If you’re able to do that and make prudent investments with the money you will have no worries when it comes time to retire (you may even be able to retire early if you’re lucky!).

Tax advantages of long term investing

I'd like to discuss the beauty that is called capital gains tax (it's beautiful relative to regular taxes anyway). What's so great about it? Well you are only taxed on HALF of your capital gains.

The basic math:
$1000 income from working (say 30% tax rate) = $300 tax bill ($1000*30%)
$1000 from capital gains (same 30% tax rate) = $150 tax bill ((1/2)*$1000*30%)

When you're investing for the long term, the majority of your wealth creation comes from capital gains. As a result you get to enjoy the very advantageous capital gains tax. Since it's long term you also don't pay the tax for a few years either. Deferred taxes at an advantageous rate? I'll take 3!

Check out this video showing the legendary Warren Buffett (he's probably my hero with Wolverine or something coming in a close second) talking about how he pays a lower % tax rate than his receptionist:



(I'm sort of technically challenged so I can't quite figure out how to insert a YouTube video here .. if anyone wants to let me know in a comment that would be greatly appreciated!!)

EDIT: You guys rock! Thanks for the help getting this video posted!!