Right now, we are in the middle of the so-called Registered Retirement Savings Plan (RRSP) season. Currently, Canadians are bombarded with financial institutions soliciting them to contribute to RRSPs by March 1st. The decision to contribute to an RRSP should not just be looked at to reduce your taxable income or generate a tax refund. Its not the only way to go.
When the Tax Free Savings Account (TFSA) was introduced in 2009, Canadians suddenly had another tax-saving tool. But it also created a new dilemma. How you shelter income isn’t as clear-cut as it once was. To reduce taxes and build savings, the TFSA offers its own advantages over the traditional RRSP.
RRSPs and TFSAs can work together in helping you achieve your goals. Ideally, by contributing to both plans you’ll be able to maximize your tax savings. But emphasizing one option over the other can make sense, depending on your current circumstances, future expectations, and overall financial life plan.
RRSPs and TFSAs have a common ability to shield your income from tax. Practically every investment that’s RRSP-eligible can be held in a TFSA, from segregated and mutual funds to stocks to GICs and savings accounts. However, it’s the differences between them that have important implications.
Maximum contributions – The TFSA annual contribution limit for 2018 is $5,500, and the total accumulation limit allowed is now $57,500. Contribution room is cumulative and will be carried forward indefinitely. How much you can put annually into an RRSP is dependent on how much you make. For 2018, the maximum RRSP contribution is 18% of your 2017 earned income to a potential maximum of $26,010. That means if you’re a high, or even a moderate-income earner, the greater contribution room available through an RRSP can help you build tax-sheltered saving faster than through a TFSA.
Contributions and withdrawals – TFSA contributions are not tax deductible, while RRSP contributions can be deducted to reduce your taxable income. Because TFSA contributions are made from after-tax income, there’s no tax to pay when those funds are used later. Putting money into an RRSP will give you a tax deduction today, but also leaves you with a future tax obligation. You’ll still enjoy tax-deferred growth while those funds remain invested, but remember that you’ll eventually owe tax when they’re withdrawn.
Re-contribution – Both RRSPs and TFSAs allow you to carry forward unused contribution room indefinitely. But that’s where the similarity ends. For flexibility, TFSAs have the edge. When you withdraw from a TFSA, that amount is automatically added to your contribution limit for the next year. This allows you to re-contribute funds repeatedly. RRSPs do not have the same benefit. When you withdraw funds, your contribution room is gone for good. You can’t simply “put back” the funds as you can with a TFSA, unless you’re doing so through an approved program like the Home Buyer’s Plan or Lifelong Learning Plan.
Government benefits – Once you retire, having a high income can impact benefits you receive from government, including Old Age Security (OAS). Withdrawals from an RRSP must be counted as income for tax purposes, so they have the potential to not only bump you into a higher tax bracket, but also leave you open to a “claw back” of benefits. TFSAs don’t create the same problem. Withdrawn funds aren’t added to income, so there’s no risk to your benefits. There are some situations, however, where contributing to RRSPs can enhance means-tested benefits. For example, if you’re eligible for the Canada Child Tax Benefit (CCTB), an RRSP deduction lowers your taxable income helping you qualify for a larger payment.
Estates – A TFSA can be transferred to a surviving spouse tax-free, while generally the transfer of an RRSP simply delays taxes until the surviving spouse’s death or when the money is finally taken out.
When you’re saving for the long-term, does an RRSP or TFSA give you the best chance at a larger nest egg? The answer depends greatly on what your tax rate is now and what you expect it to be in the future. If your marginal tax rate stays the same, it won’t matter. Investing identical amounts in each option, assuming the same rate of return and investment period, will yield the same result.
Although tax on your earnings leaves you less money to compound in a TFSA, you won’t pay any more taxes on your investment’s growth. On the other hand, avoiding taxes upfront lets the full amount of your RRSP contribution grow, but you’ll give back a chunk when the funds are withdrawn.
Where the situation is different, and where one choice can be better than the other, is if the tax rate you’re paying when making your contribution is higher or lower than it will be when the funds are taken out. The more rates change, the more advantage there is.
While marginal tax rates have a strong influence over the RRSP/TFSA decision, there’s often more to figuring out which is the best option in the bigger picture. Here are some additional key factors to keep in mind.
TFSA and RRSP don’t have to be either or. Think of the RRSP and TFSA as complementary rather than competing options for your money. Each has unique advantages and disadvantages. The TFSA’s flexibility makes it ideal when saving for short-term goals like a vacation or home renovation. For retirement savings, RRSPs might take priority.
Which option you favour can also change at different points in your life. For example, someone relatively early in their career may be better off sheltering money in a TFSA to start, and then transferring those funds to an RRSP and claiming a larger tax deduction once they’re earning a higher income.
If you’re already maximizing your RRSP contributions or have limited contribution room because of a company pension plan, a TFSA can boost your tax savings.
If you’re over 65 and convert your RRSP to a RRIF or annuity, that pension income can be eligible for income splitting. If you have a spouse in a lower tax bracket, splitting your retirement income with them can reduce your combined tax bill and leave more of your RRSP in your hands. You’ll be able to enjoy much higher retirement income before there’s any danger of a claw back in benefits.
If you want frequent and easy access to your sheltered funds, the TFSA is the way to go. You won’t pay tax on every withdrawal like you will with an RRSP. And, you can re-contribute the funds in future years, so they’ll be there when you need them.
But if you’re having a hard time staying disciplined with your savings, will having easy access to your funds in a TFSA be too tempting? If you choose an RRSP instead, knowing you’ll have to pay tax on every withdrawal might be the deterrent that keeps your plan on course.
Remember that the tax benefits of TFSAs and RRSPs won’t mean as much if poor planning elsewhere is costing you. If you do contribute, make sure you’ve organized your assets tax efficiently. That means sheltering your fixed income investments and leaving equities in a non-registered account.
The RRSP contribution deadline for the 2017 tax year is March 1, 2018. Northern River Financial, your Financial Life Planning Partner, can review your situation and goals to help you use TFSAs and RRSPs to your best advantage. Contacting us ensures you’re Keeping Life Current.