By Daniel Machado
Whether you are new to Canada or old, the rising unaffordability in the cities is inescapable. How do you know where to invest and how?
A Historic Overview of the RRSP and TFSA
The introduction of the Tax-Free Savings Account (TFSA) in 2009 represented the most important change to the way Canadians saved money since Registered Retirement Savings Plans (RRSPs) were launched in the 1950s.
Both RRSPs and TFSAs provide investors with an opportunity for tax-effective investment growth.
But unlike an RRSP, contributions to a TFSA are not tax-deductible, and amounts can be withdrawn tax-free at any time, and withdrawn amounts are added back into your TFSA contribution room the following year.
Which is Better?
Looking at your pre-retirement and expected post-retirement marginal tax rates can help you determine how to best allocate your investments. Say hello to Ali and Maryam, a couple who are also Canada’s newest residents. If Ali expects to be in a lower tax bracket during retirement, contributing to an RRSP is generally more beneficial. However, if Ali expects his tax bracket to be equal or higher than his pre-retirement tax rate, the TFSA might be more tax-efficient.
Hold On; Not So Fast
If only things were that simple! There are a few more factors that Ali and Maryam need to consider.
Even while expecting to have a lower marginal tax rate in retirement, maximizing RRSP contributions may not be the most tax-efficient long-term strategy. RRSP withdrawals (directly or through a registered retirement income fund (RRIF) or an annuity) increases taxable income. Let us say that Ali’s earned annual income is $100,000 and Maryam is the homemaker and works part-time earning $20,000 per year. Their retirement goals can be reached using both types of accounts. Ali would likely use an RRSP to lower taxable income and receive a refund, while Maryam would likely save money using a TFSA because she will continue with an equal tax rate from pre-retirement to retirement.
On the other hand, if the expected marginal tax rate in retirement is equal to or higher than during the accumulation years, contributing to your TFSA is not always the best approach. For example, RRSPs that are converted to a RRIF at the end of the year that you turn 71 years old or an annuity after the age of 65 can produce income that is eligible for the pension income tax credit, qualifying you for pension income splitting. Other income-splitting strategies such as spousal RRSPs could distribute a portion of your taxable income to a spouse with a lower marginal tax rate in retirement, further reducing your tax bill and reducing the claw-back effect on your income-tested benefits and credits.
Comparing the RRSP with the TFSA
| Registered Retirement Savings Plan (RRSP) | Tax-Free Savings Account (TFSA) |
| Fully tax-deductible contributions subject to available room | Contributions are not tax-deductible and subject to available room |
| Contributions can be made until the end of the year in which you turn 71 years of age | Contributions can be made at any time with no age limit (for anyone 18+ years of age) |
| Withdrawals are taxed at your marginal tax rate | Withdrawals are 100 percent tax-free |
| Withdrawals could affect eligibility for income-tested government benefits and credits | Withdrawals will not affect eligibility for federal income-tested government benefits and credits |
| Unused contribution room is carried forward indefinitely | Unused contribution room is carried forward indefinitely |
| Withdrawals cannot be returned to the RRSP without using contribution room | Withdrawals will be added to contribution room in the following year |
Where does this Leave You?
An RRSP is definitely a long-term investment vehicle. The taxes and lost contribution room associated with early withdrawals are strong incentives to keep your money invested until retirement.
A TFSA may be better suited for shorter-term goals, such as an emergency fund or saving for a major purchase, since there is no tax on withdrawals, and withdrawn amounts are added back into the TFSA contribution room the following year. Although a TFSA can also be a retirement savings tool, because you can easily withdraw those savings (no taxes on withdrawals or loss of contribution room), you must resist the temptation to dip into it prior to retirement to fully benefit from its potential as a source of retirement income.
Remember, there is no one-size-fits-all solution. Your personal savings strategy needs to consider your unique circumstances as well as your short and long term objectives.
Struggling to find a better footing with savings? Your Investors Group Consultant can help determine your best options.
Daniel Machado is an Associate Consultant at the Investors Group Financial Services Inc. and can be reached at Daniel.Machado@investorsgroup.com.
Photos by Fabian Blank and Michelle Henderson on Unsplash.
