RRSP vs. TFSA: Which Is Better for Gen Z?

Silver coins fall into a piggy bank.

Generation Z is reaching adulthood. The oldest members of the generation are 26; the youngest are 11. It took a while, but the millennials’ younger cousins are coming of age.

If you’re a member of generation Z, it would be a good idea for you to start planning for retirement. Yes, you heard right. Although you may feel like you’re too young to start thinking about retirement, the truth is, you should start thinking about it as soon as you start working. As we age, the passage of time seems to accelerate — many people report feeling like they reached retirement age “in the blink of an eye.”

If you’re in your early/mid-twenties, you most likely already have a job. That means you have the ability to save money. While many young Canadians bemoan the cost of housing, the fact is that everybody can manage a meagre amount of savings — let’s say, $100 per week. If you save that much weekly and invest all of it, you could end up with a several hundred thousand dollar account balance when you retire.

The question is, where do you put your savings? As you may know, the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA) are the two main accounts that Canadians use to save for retirement. The former gives you a tax deduction, while the latter keeps your investments tax-exempt, even when you withdraw them. Each has its own benefits and drawbacks. In this article, I will explore the pros and cons of RRSPs and TFSAs, so you can decide which account is best for you.

The benefits of an RRSP

The RRSP has two main benefits that TFSAs don’t have:

  1. A tax deduction
  2. A larger contribution limit

You get a tax deduction when you contribute to an RRSP, lowering your tax bill for the year in which you make the contribution. The TFSA does not have this benefit. Additionally, RRSP contribution limits can be quite large. Your contribution limit is either $30,780, or 18% of your income, whichever is lower. So, you can fit a lot of investments into an RRSP for tax-free compounding.

The benefit of a TFSA

The main benefit of a TFSA over an RRSP is the fact that the money is not taxable upon withdrawal. In an RRSP, investments grow tax-free, but you ultimately pay taxes on them when you convert them into cash and withdraw. This does not happen with TFSAs: they are 100% tax-free even on withdrawal. This makes TFSAs particularly useful accounts for dividend stocks.

Consider Toronto-Dominion Bank (TSX:TD), for example. It’s a Canadian bank stock with a 5% dividend yield at today’s prices. Next year, Canadians who were 18 or older in 2009 will have $95,000 worth of TFSA contribution room. If you invest that much money at a 5% yield, you’ll get $4,750 per year in annual dividend income, assuming the stock’s yield doesn’t change.

Now, of course, TD’s dividend could change. Historically, it has tended to go up. In the future, if a Great Depression-style event occurs, it could conceivably go down. You should never put 100% of your money in just one stock, unless you have some kind of special “edge” in understanding the company’s prospects. Nevertheless, TD’s 5% yield goes to show that a lot of passive income can accumulate inside a TFSA. Just make sure you aim for a diversified portfolio yielding 5%, not a single stock portfolio made up of nothing but TD Bank!

The post RRSP vs. TFSA: Which Is Better for Gen Z? appeared first on The Motley Fool Canada.

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Fool contributor Andrew Button has positions in Toronto-Dominion Bank. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.