We are lucky as Canadians to have access to a variety of tax-sheltered accounts (including RRSP and TFSA) that we can use to grow our retirement pots and/or save in general. Deciding between TFSAs vs. RRSPs can be a tricky decision to make. Both accounts work well for the general purposes they were intended for, but based on your specific circumstances, it may be in your best interest to choose one account over the other.
Before delving into when you should choose a TFSA account over a RRSP, let us quickly summarize their individual characteristics:
Overview of the TFSA
The Tax-Free Savings Account, popularly known as TFSA, is a savings tool introduced by the government in 2009. It allows Canadians who are 18 years of age or older to save or invest a certain amount per year based on contribution limits that are announced annually. For 2018, the annual contribution amount is $5,500.
If you are unable to use up your contribution room for the year, you can carry it forward to future years indefinitely. If you have been eligible to contribute to a TFSA since its inception and have never contributed, your contribution room is now $57,500.
The investments you can hold in your TFSA account are plentiful, including stocks, bonds, ETFs, mutual funds, index funds, GICs, cash, and more. Earnings (or interest) realized on your TFSA investments/savings are sheltered from taxes for life. However, unlike the RRSP, your initial contributions to the account are not tax-deductible.
Further readings: 5 Ways To Invest Your TFSA
Overview of the RRSP
The Registered Retirement Savings Plan is an account introduced in 1957 which allows Canadians to save towards retirement using tax-deductible contributions. Each year the government stipulates the maximum portion of “income” that you can contribute to your RRSP account. For 2018, it is 18% of your earned income up to a maximum of $26,230.
Like the TFSA, unused contribution room can also be carried forward to future years, however, you can no longer contribute to a RRSP after age 71. Earnings on your RRSP investments are sheltered from taxes until when you withdraw funds.
Unlike the TFSA, your contributions to an RRSP account are tax-deductible, meaning that you do not have to pay taxes on the portion of income you contribute to the account.
TFSA vs. RRSP
Going back to our original question, “which account should you choose between the RRSP and TFSA?” In an ideal world, you should choose both accounts and max out your contributions to both of them. However, that is not always feasible because the average Canadian does not just have enough funds to max out both accounts.
So, if you have to choose between contributing to the TFSA or the RRSP, here are a few points to use as a guide:
1. Tax Bracket Now and In Retirement
In general, if your tax bracket (or marginal tax rate) now is likely going to be higher than your tax bracket in retirement, an RRSP account is preferable to a TFSA. The reasoning behind this is that your tax savings now (via tax-deductible contributions) will be more than the taxes you pay in retirement when you start withdrawing funds from your RRSP.
For example, assuming you earn $95,000 in Manitoba (marginal tax rate of 43.40%) and contribute $10,000 per year. If you retire in 30 years with an income of $60,000 and a marginal tax rate of 33.25%, what’s your first $10,000 contribution going to look like under both accounts? In this scenario, you are better off maximizing your RRSP before your TFSA:
*When the tax rate is lower in retirement, the RRSP wins.
On the other hand, if your marginal tax rate now is lower than what it will be when you are retired, it generally makes sense to prioritize your TFSA account over your RRSP. This is because your tax savings now will be less than the taxes you are required to pay when you withdraw funds from your RRSP in retirement.
For example, let assume a reverse of the example above i.e. that your current marginal tax rate is 33.25% and your tax rate in retirement is 43.40%. For the same contribution of $10,000 in a RRSP vs. TFSA, you have:
*When the tax rate is higher in retirement, the TFSA comes out on top.
2. Starting Out in the Workforce
When you are just entering the workforce and earning a starting (small) salary, it is preferable for you to prioritize your TFSA. A small salary means a lower marginal tax rate and lower tax savings on your contributions.
For example, if you earn $35,000 in Manitoba, your marginal tax rate is 27.75%. This means that a contribution amount of $5,000 to your RRSP will save you $1,387.50. Compare that to a higher-income earner who makes $75,000 and a marginal tax rate of 37.90%. For the same RRSP contribution amount of $5,000, they generate tax savings of $1,895 (37% more).
Contributing to a TFSA does not affect your RRSP contribution room…it will continue to grow and can be used up when your income and marginal tax rate increases and you can get more in tax deductions.
3. Income in Retirement
When you withdraw funds from your RRSP in retirement, it counts towards your overall taxable income and can impact other income-tested benefits you qualify for. For example, if your total retirement income in 2018 exceeds $75,910 (combination of pensions, RRSP, CPP, OAS…and excluding TFSA), the government will clawback some of your OAS benefits (at the rate of 15 cents for every $1 over the threshold amount).
However, if your total income excluding TFSA is $60,000 and you withdraw $15,911 from your TFSA (for an overall income of $75,911 for example), you will not suffer OAS clawback since the TFSA amount is not considered taxable income. Essentially, depending on how high your retirement income will be, generating income from a TFSA account can help you keep most or all of your government benefits.
Further reading: 10 Ways to Minimize or Eliminate OAS Clawback
If you expect to qualify for Guaranteed Income Supplement (GIS) benefits, a TFSA is a better option as well, since RRSP income could put you over the income threshold required to qualify for GIS.
4. Saving for Retirement – Maybe?
RRSP accounts were designed for retirement savings, period. Not for emergency funds or to serve as your piggy bank. If you decide to start withdrawing funds early for other purposes, you will have to pay taxes immediately (via withholding taxes) and will lose that contribution room permanently. Exceptions to this include withdrawals under the Home Buyers’ and Lifelong Learning plans.
If you want a savings pot that you can access with some flexibility, such as for a home down payment, wedding , vacation, etc., a TFSA is preferable. Withdrawals can be re-contributed the following year and contribution room is not lost. In addition, funds withdrawn are not included in your income and no tax is due.
5. Saving for Retirement with no Income
Your total RRSP contribution room is based on your earned income from prior years. Earned income refers to income from employment, rental properties, business income, research grants, royalties, etc. If you do not have “earned” income, and want to grow your retirement pot using a tax-sheltered account, a TFSA is your only choice. You can put cash gifts, cash inheritance, and more in your TFSA.
6. Saving While Retired
At age 71, you can no longer contribute to an RRSP. However, there is no age limit for a TFSA account. You can save any excess funds you have in a TFSA and have it grow tax-free.
7. Group RRSP
If you are enrolled in a Group RRSP at work and your employer offers contribution-matching, it makes sense to take advantage of this ‘free’ money offer and prioritize your group RRSP contributions over the TFSA. Check out this article for more on Group RRSPs.
Both the RRSP and TFSA are great accounts and you should utilize them both whenever possible. If you max out your contributions to one account and still have funds to invest, put them into the other account. You will be thankful you did when retirement comes knocking!
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