The parable of the twins (RRSP vs TFSA)

By Robb Engen, Boomer & Echo

Special to the Financial Independence Hub

Fashionable girls twins walk in the street

There’s a popular story told by banks and financial authors to encourage people to start saving for retirement at an early age. It’s called the Parable of the Twins and it goes something like this:

One twin puts aside $3,000 every year into his tax-free savings account starting at age 22, and stops at 32 – never adding another penny to the account. His sister starts saving $3,000 annually at age 32, and continues until 62. Who has the larger nest egg?

RelatedHow much of your income should you save?

You know how this story goes by now. Assuming an annual return of eight per cent, the twin brother wins hands-down. He ends up with $437,320 in his TFSA, compared to his sister’s $339,850, even though he contributed $60,000 less than his sister.

It’s a ubiquitous tale, but one that resonated with me at a young age. I was drawn to the awesome power of compounding – how money grows exponentially over time.

Funny enough, here I am, about to turn 36, and I’ve got roughly $120,000 saved in my RRSP with no intention of adding big dollars to this portfolio in the future. Now it’s time for me to let compounding do its thing. On the other hand, I’ve got nothing saved inside my TFSA and feel like I’m falling behind – especially with the recent increase to contribution limits.

Brother twin – My RRSP

I built up a lot of RRSP contribution room early in my career, and I’ve spent the last few years catching up. For example, I put $26,000 into my RRSP in 2013 and added another $10,000 last year.

My 2015 deduction limit is about $9,000 and each year due to a hefty Pension Adjustment I generate about $3,000 worth of contribution room.

So what will that mean for my RRSP? I’ve already put the portfolio on cruise control by switching to a broadly diversified two-fund solution (VCN – Vanguard’s Canada All Cap ETF, and VXC – Vanguard’s All-World ex Canada ETF).

I expect an annual return of eight percent before inflation. In twenty years, assuming annual contributions of $3,000, the portfolio will grow to about $700,000.

Once I max out my RRSP contribution room, I’ll start pouring money into my tax-free savings account.

Sister twin – My TFSA

Like the sister twin, I’m getting a late start on my TFSA. Unlike the sister twin, I’ll build a bigger portfolio by boosting my savings rate over time. Assuming annual contributions of $10,000, my TFSA account should be worth roughly $460,000 in twenty years.

Age 55 is an ideal target for early retirement goals. My strategy is to build up three buckets of income to draw from in retirement and then figure out the most efficient use of each. That could mean melting down my RRSP from age 55-65 and stashing away some of those withdrawals into my TFSA.

While the RRSP melts down, the TFSA continues to build up. From 55-65, assuming the $10,000 annual contributions continue, my TFSA could be worth over $1,000,000.

The retirement puzzle

The final piece to consider is when to retire. As I mentioned, a juicy defined benefit pension could also be on the horizon. So how does that fit into the puzzle? I haven’t figured that part out yet, I’m afraid. It’s a long way off, and a lot can change along the road to retirement.

RelatedThe battle between your present and future self

I do know that by harnessing the power of compounding, my brother twin portfolio (RRSP) will continue to grow, and by ramping up my savings rate for the next twenty years, my sister twin portfolio (TFSA) will thrive, giving me plenty of options for retirement.

RobbEngenIn addition to running the Boomer & Echo website, Robb Engen is a fee-only financial planner. This article originally ran on his site on June 4th and is republished here with his permission.

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