The beginning of the year is as good a time as any to review your financial plan and it also means we all gain another $5,500 of TFSA contribution room. For many, they are also beginning to think of their 2016 tax situation and their corresponding RRSP contributions; this year’s deadline is March 1, 2017. Whether you should invest in a Tax Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP) is a question that affects many investors. For most, the answer is a bit of both. If you have an upcoming short or medium-term need, such as requiring funds in five years or less, the untaxed TFSA withdrawals is likely the right choice. For longer term, such as retirement, RRSP contributions may be best. The key is to estimate the trend in your future income (will it increase, stay the same, or possibly fall) and to minimize taxes over the long-term.
What is the Difference?
Both RRSPs and TFSAs can contain the same type of investments whose growth and income are sheltered from taxes. This includes cash and cash-like instruments, GICs, stocks, exchange traded funds (ETFs), mutual funds, and bonds. However, the two investment options act very differently when it comes time to withdraw funds; RRSP withdrawals are taxed, TFSA withdrawals are not.
Tax Free Savings Account
First, if you don’t already have a TFSA account I recommend opening one. When you open a TFSA account you can contribute all of your allowed contribution room at once or disperse contributions throughout the year. Anyone over eighteen years old with a valid Social Insurance Number can open a TFSA.
For Canadians who have become non-residents, or for non-residents who pay Canadian tax, there are additional rules that you should be aware of. If you have foreign citizenship or ties to another country, contact your wealth advisory team or the Canada Revenue Agency (CRA) to verify the country’s contribution room before making a deposit to your TFSA.
Available contribution room is readily obtainable from the CRA and avoiding over-contributions is very important as the penalty of one percent of over-contribution per month is substantial. Keep in mind that CRA has your available contribution room as of January 1 of the current year. This does not include any deposits you have made during the current year.
An important distinction between TFSAs and RRSPs is that upon a TFSA withdrawal the allowed contribution room is not lost; rather, it becomes available again in the next calendar year. Many investors will incur over contribution penalties because they innocently recontribute the amount they withdrew in the same calendar year, creating an over contribution. Simply wait until the next calendar year and the amount you withdrew in the prior year will be added back to your available contribution room.
As of January 1, 2017 the cumulative limit for TFSA contribution is $52,000 per person. Therefore a couple could contribute a combined total up to $104,000 to their TFSAs. If they each earned 5% annually, they could leave this inside their TFSAs to grow further, or withdraw it with no tax obligations on the combined $5,200 in income.
For comparison, if the couple earned $5,200 in a joint, non-registered account it could be subject to a combined Federal and Provincial income tax of up to 53% or $2,756, leaving only $2,444 after-tax. Any investor who has funds in a non-registered account, and who hasn’t made any TFSA contributions, will certainly benefit from a TFSA.
Registered Retirement Savings Plan (RRSP)
Each year you can make an RRSP contribution of up to eighteen percent of earned income from the previous year, less any pension adjustments. There are maximum contribution limits and for the 2016 tax year the maximum allowed contribution is $25,370, up from $24,930 in 2015. Unused contribution room can be carried forward indefinitely.
Your allowed amount is available online with your CRA ‘My Account’; you can also find this information on your Notice of Assessment or Notice of Reassessment which the CRA sends after reviewing your annual tax return. In order to be eligible for RRSP contributions, an individual must earn an income and file a tax return.
How Do They Compare?
RRSPs and TFSAs were created with different goals in mind which explains their different behavior in relation to taxes.
Moneysense.ca explains nicely:
"With an RRSP, you can deduct the contribution from your income, which earns you a tax refund, but the money becomes fully taxable when you take it out. The TFSA is the reverse: you don’t get a tax break on contributions, but you don’t pay tax on withdrawals either.
So if you’re deciding between the two options, the question boils down to whether you should pay the taxman now or later."
A good guideline to follow is: "If your income (and therefore your tax rate) is greater now than you expect it to be during retirement, go with the RRSP; if it’s lower now, go with the TFSA." Of course, individual circumstances will vary and this is a general guideline only; please speak to your Wealth Consultant regarding your financial situation.
Most people with a high salary and secure pension plan find more benefit from the TFSA because the pension joined with Old Age Security (OAS) and the Canada Pension Plan (CPP) could potentially increase their income high enough to prompt a claw-back of OAS when they withdraw from their RRSPs.
RRSPs however, are the most sensible for the majority of people, notably those without a pension plan. Those who don’t have a large income when they retire, can immediately invest the tax refund received and benefit in the long-term from compound interest.
Pros of RRSPs/RRIFs
Cons of RRSPs/RRIFs
Pros of TFSAs
Cons of TFSAs
The key to choosing between TFSA and RRSP contributions is comparing your current income and marginal tax rates to your estimated retirement income and liquidity needs. We all know diversity is key for a successful investment portfolio and the same holds true for your TFSA and RRSP; both have important functions within your comprehensive financial plan. In an ideal situation, you will want to utilize both in your portfolio.
If you wish to discuss your cash flow and tax projections as part of a comprehensive financial plan, feel free to call one of our experts