By Rick Sidhu CPA, CGA
Choosing between putting your money in a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA) can be difficult.In the ideal world, you would want to max out both your RRSP and TFSA. However, it is often very difficult to be able to scrounge up the money to max out both accounts. So the question is, where should you put your money?
If you earned income in a prior year and was subject to Canadian taxation, then you may contribute to an RRSP. Your RRSP can hold a combination of eligible investments, such as Guaranteed Investment Certificates (GICs), stocks, mutual funds, and bonds. Contributing to the RRSP is done with pre-tax income. Your contribution room is based on 18% of your gross income or $25,370 (as of 2016) – whichever is lower. Any unused contribution room can be carried forward to the following year.
Your RRSP is a tax deferral vehicle–you will be taxed on the funds when withdrawn. That said, you would rather pay $1 of income tax tomorrow than $1 of income tax today. Actual tax savings will result if you are in a lower tax bracket when you withdraw the funds.
As a result, RRSPs can be tax-effective investment vehicles, especially if you are many years from retirement. If you do decide to take advantage of an RRSP, contribute at the beginning of the year to start the tax-free compounding your earnings earlier. Also consider monthly contributions to your RRSP throughout the year. Your RRSP contributions are tax deductible and can be deducted when the contribution is made in the calendar year or the first 60 days of the following taxation year.
You can make an RRSP contribution in a year and not claim a tax deduction in that year if you think your marginal tax rate will be higher in a later year. This could be a substantial advantage if you claim the tax deduction in a year or years when you are in a higher tax bracket. You will still benefit from the tax-deferred earnings.
Your RRSP matures in the year you turn 71. When your plan matures, the funds must be transferred to a registered retirement income fund (RRIF), or the plan is collapsed and all the funds in the plan are subject to tax.
Since 2009, individuals 18 years or older, who are residents of Canada for income tax purposes can contribute to a Tax Free Savings Account. For 2016, the contribution amount is $5,500 and the total TFSA contribution room is $46,500. Over contributions are subject to a penalty. Any unused contribution room from earlier years can be carried forward to future years.
Contributions to a TFSA are not tax deductible and the contribution room can be carried forward indefinitely. The Canada Revenue Agency only tracks TFSA contribution room for eligible individuals who file personal tax returns, which means you should file a return if you are 18 or older even if you do not have any taxable income.TFSAs generally can hold the same investments as RRSPs. This includes cash, mutual funds, publicly traded securities, GICs, bonds, and certain types of shares of small business corporations. You can incur penalties if your TSFA holds investments that are deemed a “prohibited investment”.
Unlike RRSPs, your TFSA contribution room is not lost when you make a withdrawal. When you make a withdrawal, the amount withdrawn will be added to your contribution room for the following year and can be re-contributed in the future. In addition, you do not have to wind it up when you reach age 71. Your TFSA can be maintained for your entire lifetime.
So which is better?
Both RRSP and TFSA offer a tax benefit. The difference is that there is no immediate tax advantage to be gained from TFSA contributions. In addition, given that RRSP withdrawals being taxable, it should be a powerful motivator to keep your money in your RRSP. It’s meant to help you think twice before drawing down retirement savings.
When you retire and begin to collect government payments such as Old Age Security (OAS), the government takes your RRSP withdrawals into consideration when “clawing back” your OAS – but this is not the case when withdrawing from TFSA. So if you are likely to depend on government retirement benefits, consider putting your money in a TFSA as opposed to a RRSP to minimize the “claw back” on your OAS.
Just like your RRSP, your investments can compound inside your TFSA tax-free. This can make a huge difference if you start your TFSA contributions early.
There’s no right or wrong if you go with either the RRSP or TFSA. Just remember not to spend your tax refund if you contribute to an RRSP and not to spend your TFSA if you contribute to a TFSA. Remember, you are saving for the future.
For more information on RRSP, TFSA, and retirement strategies, refer to CPABC RRSP and Tax Tips. If you have any questions about your retirement plan, be sure to consult with a Chartered Professional Accountant.