Great branding and psychological bias might contribute to the popularity of tax-free savings accounts over registered retirement savings plan accounts, new research suggests.
In 2020, the share of family savings in registered accounts was 51.8 per cent for TFSAs, compared with 31.5 per cent for RRSPs, according to the most recent data from Statistics Canada.
A team of Canadian researchers found that people’s preference for TFSAs may, in part, be due to a bias toward the label “tax-free,” even when another option might better suit their financial needs.
To prove it, they conducted experiments where participants were asked to choose between a “tax-free account” and a “retirement savings account.” Sometimes the account descriptions matched the names, and sometimes they were swapped, meaning the description of RRSPs was under the tax-free account name, for example.
Turns out, participants overwhelmingly went for the plan labelled “tax-free,” regardless of what the plan description said.
“The problem is that the average person might not be making an informed choice,” said Jonathan Farrar, an accounting professor at Wilfrid Laurier University and one of the researchers on the paper. He warns that relying too much on TFSAs without understanding how both accounts work could hurt Canadians’ long-term savings.
“They are just kind of flying by the seat of their pants.”
TFSAs and RRSPs are both tax-sheltered accounts, but they work differently. With a TFSA, you contribute after-tax dollars, and withdrawals are tax-free. With an RRSP, contributions are tax-deductible, but you pay tax when you withdraw money.
TFSAs have only been around since 2009, but their popularity took off quickly. By 2014, the average contribution to TFSAs exceeded those for RRSPs, despite RRSPs offering tax breaks on contributions, higher annual limits and about a 50-year head start.
Dr. Farrar said this is partly due to mental shortcuts that people use to make complex decisions.
“They are looking at the ‘tax-free’ and saying, ‘That’s what I want,‘” he said. “They’re not giving careful thought to anything else.”
Sam Lichtman, founder and certified financial planner at Millen Wealth Advisors in London, Ont., has seen this firsthand.
Many of his clients say they prefer TFSAs but when asked to explain how the account works, they often have a poor understanding. “It speaks to the basic financial literacy that a lot of Canadians don’t have,” he said.
He tries to avoid influencing his clients’ decisions by using different names – calling RRSPs “salary deferral plans” and TFSAs “tax now, tax-free later.”
The risk of relying too much on TFSAs is that people often withdraw money from them because of the tax benefits, which makes it harder to build long-term savings, Dr. Farrar said.
“People are no longer accumulating long-term savings that they would have, had all the funds been left in the RRSP,” he said. “People are using the TFSA more as a bank account.”
In 2021, the average TFSA contribution was $10,055, but the average withdrawal was $9,823, according to the Canada Revenue Agency.
Dr. Farrar also cited a 2019 paper that found as TFSA contributions go up, RRSP contributions go down. Based on data from a sample of 20 per cent of all Canadian tax filers, the authors found that for every 1-per-cent increase in TFSA contributions, RRSP contributions drop by 0.4 per cent.
It’s not necessarily a bad thing to favour your TFSA account over your RRSP, said Caval Olson-Lepage, a certified financial planner in Saskatoon.
If you’re in a low tax bracket or get a refund, a TFSA might be better, she said. If you’re earning more and in a higher tax bracket, an RRSP could save you more in taxes.
The important thing is to not get influenced by the titles of the accounts, Dr. Farrar said. When weighing options between the two accounts, he advises Canadians to ignore the names and focus on how the accounts work.
Mr. Lichtman said that “you don’t have to sacrifice the TFSA to contribute to an RRSP.” He suggests using the tax break you get from your RRSP contributions to fund your TFSA. “You can kind of have the best of both worlds.”