One question that comes up all the time in my work (especially for younger investors) is whether to save in an RRSP or TFSA. Both are good options, but there are definitely times of your life when one has an advantage over the other. Today we’re going to talk about when that’s the case and why.
Everyone knows that the best part of an RRSP is that you get money back on your taxes when you make a contribution. Do you know how that process works, though? RRSP contributions are subtracted from your overall income which makes your income lower and less income means less tax. RRSP contributions then grow tax-free for as long as the funds are held within the account. That sounds great, right? Well yes, but the thing people sometimes forget is that the tax isn’t gone forever, you have to pay tax when you make withdrawals from your RRSP. This doesn’t completely defeat the purpose, though! Your goal for RRSP’s should be to make your contributions when you are in a high tax bracket and make your withdrawals when you are in a low bracket. Let’s look at a quick example. Say you are 35 years old and earning $150,000/year; that would have you in the 41% tax bracket. If you make an RRSP contribution of $10,000, you will get a refund of about $4,100. If you then leave that money in an RRSP until you are 65 and withdraw it with an income of $50,000 your marginal tax rate will be 30.5%, meaning you would pay $3,050 in tax. That would give you a tax savings of $1,050. Doing that every year would really start to add up! However, if you made the contribution at the same marginal tax rate as you withdraw it, you wouldn’t get the same advantage.
What about TFSA’s, what’s great about them? Well, TFSA’s don’t give you a tax refund when you make a deposit but they allow your money to grow tax-free and you NEVER have to pay tax when you make withdrawals. That means that you could potentially deposit $1,000 to your TFSA, buy a stock that quadruples and grows your deposit to $4,000 and then be able to withdraw that full amount and never pay a cent in capital gains. If that same thing happened in a non-registered account, you’d be looking at a tax bill of $615 dollars if you’re income was $150,000 ($3,000 of growth times a capital gains tax rate of 20.5%). Sheltering as much of your non-registered money as possible within a TFSA can save you a lot of money in tax over your lifetime. The TFSA was started in 2009 and as of January 1, 2017 the total contribution room is sitting at $52,000. You have to be 18 years old and a Canadian citizen to contribute, so if you only turned 18 after 2009, you would have to subtract those years of available room. The annual contribution limits have played out as follows:
|2009 - 2012||$5,000 / year|
|2013 - 2014||$5,500 / year|
|2015||$10,000 / year|
|2016 - 2017||$5,500 / year|
So, which is better?
The answer really depends on the purpose of the money you are saving. If you are saving for a shorter term goal (buying a new car, going on vacation, etc.), then the TFSA is your best bet because you can withdraw the funds at any time without paying tax. You also get back your contribution room the following year after a withdrawal. If you are instead saving for retirement, then you want to look at what the potential difference between what your marginal tax rate is now and what it will likely be in retirement. Most people’s incomes drop substantially in retirement, but if you are lucky enough to be paying into a pension plan, you might be the exception. If your tax rate is higher now than it will be in retirement, then an RRSP is a good option. If not you might want to consider putting your savings towards your TFSA until it is maxed out and then work on your RRSP.
The one exception to the short term vs. long term rule would be saving to buy a house. Using the ‘Home Buyer’s Plan‘ allows you to make tax-free withdrawals from your RRSP to buy your first home. You do have to replace the funds, but it’s a good way to save up your down payment because you do get the added bonus of a tax refund on those RRSP contributions; every dollar counts when you’re trying to get into the housing market! Check out the linked article above for your details on the HBP.