March 21, 2017 / Published 11:07 AM EST / Rob Mann, Staff Writer
Making dollars and sense of TFSAs and RRSPs
When deciding whether to spend or invest your hard-earned cash, it’s hard to resist the temptation to treat yourself to a shopping spree or much-deserved getaway. While both of those options sound incredibly fun, investing is probably the smarter the way to go. Once you’ve come around on that decision, there’s another choice to make: should you put your money in a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA)?
The RRSP was created by the Canadian government to motivate people to save by deferring the taxes, and we love it because those tax-deductible contributions can lead to a sweet, sweet tax refund. Not bad, right?
On the other hand, a TFSA is almost the polar opposite of an RRSP. You can contribute up to $5,500 to your TFSA each year, and you won’t pay a dime of taxes on any capital gains, interest or dividends earned in your account. However, you can’t deduct your contributions come tax time, like you can with an RRSP.
As you may have guessed, there’s far more to each account type than tax refunds and contribution limits. So let’s talk about that.
An RRSP is the one we grew up being told is an absolute must for retirement savings, and for good reason. You can contribute up to 18% of your earned income, to a max of $26,010, and the taxes on your contributions are refunded to you each year. There’s a bit of a catch, though, as you will pay taxes when you withdraw the money once you retire, making it a tax-deferred account, not tax-free. The benefit is that you’re typically at a lower tax bracket in retirement than during your working years, so you’ll keep more of your money over the long run. If you ever need to take money from your RRSP before retirement, there are a couple of scenarios where you can borrow without penalty:
• Home Buyers’ Plan (HBP): first-time home buyers can borrow up to $25,000 from their RRSP, but the funds must be re-paid to your RRSP within 15 years.
• Lifelong Learning Plan (LLP): going back to school? You can borrow up to $10,000 per year, to a max of $20,000 to finance full-time studies for you or your spouse, and you have 10 years to re-contribute that money to your account.
Why we love the RRSP
• Saving with an RRSP is the priority for many of us because contributing to it may trigger a tax refund. But, as much as we may not want to admit it, it’s best to re-contribute that tax refund to really make the most of your money.
• The taxes you’ll have to pay if you withdraw money early (other than for the HBP or LLP) forces you to become disciplined with savings.
• For those in higher tax brackets, an RRSP is a gift from above, where you can park your Canadian and U.S. investments, and in retirement, withdraw your funds while in a lower tax bracket.
Things to keep in mind with your RRSP
• It’s a tax-deferred account, not tax-free. If you have a fairly generous pension, you’ll have very little RRSP contribution room, and your taxes could be through the roof when your RRSP is combined with your pension.
• Life is full of surprises, and an RRSP doesn’t provide you with much flexibility if you need to borrow from your account early on. If you do take money from your RRSP before retirement, you’ll be subject to withholding taxes, ranging between 10-30%.
• For those with lower incomes, an RRSP may not be the ideal investment tool. It won’t reward you with a big tax refund, as you haven’t paid significant taxes throughout the year.
• For those who do get a nice tax refund, if you don’t re-invest that money, you’re losing out on the real benefit of an RRSP.
For many, a TFSA simply makes sense as your primary saving and investment account. Regardless of your income, a TFSA allows you to grow your money, tax-free. It’s a great option when you’re saving for a specific, short-term goal, as you can withdraw your money at any time, without penalty. And, like an RRSP, you can hold just about any type of investment in your TFSA.
Each year, additional space is added to your TFSA contribution limit, starting in the year you turned 18. For example, if you were 18 before 2009, you can deposit up to the full $52,000 into your TFSA, and if you turned 18 in 2014, you can contribute up to $26,500. Here’s the breakdown to help determine your contribution room:
|Years||Annual limit||Cumulative limit|
Why we love the TFSA
• Need cash for a holiday, the big day, or even just a rainy day? A TFSA is super flexible, so you can access your money whenever you need it.
• Because your TFSA contributions have already been taxed, you can withdraw money from it in retirement without impacting your tax rate.
• For those with a lower income, you likely won’t get a significant tax refund from RRSP contributions, making a TFSA a better option.
• Conversely, for those with a very high income, a TFSA is also a great option for retirement saving, as you may have a high tax rate in retirement. Money withdrawn from your TFSA won’t impact your taxes at all.
• In retirement, money can be tight, and some Canadians will rely on Old Age Security (OAS) to supplement their income. Luckily, the money in your TFSA won’t impact the support you receive from OAS, unlike an RRSP.
• All capital gains, dividends and interest in your TFSA can build and compound, tax-free. If you take advantage of this early on, this will be a serious advantage in the long run.
• If you do withdraw money from your TFSA, you can re-contribute that amount in the future (but not within the same year that you withdrew money.)
• Any unused contribution room carries forward, so you can always top up your account as you’re able to.
Other things to consider with your TFSA
• That flexibility to access your money makes it too easy to take funds out of your TFSA, potentially preventing you from hitting your retirement goals.
• While many employers offer RRSP matching and contributions, very few do the same for TFSAs.
• Because most of us will earn more during our careers than in retirement, an RRSP is the account of choice for retirement contributions.
• If you’re using your TFSA as high-interest savings account with one of the big banks, you might be under-utilizing the power of a TFSA. Using a TFSA as an investment account will really put your money to work, and it’s a better use of the tax-free benefit of the account.
Which is best for you?
Before jumping head-first into either, it’s important to have an honest conversation about your finances and goals. The main question to answer is simple: what are you saving for?
Will you need to access your money for short-term goals, rather than strictly retirement? If you’re saving for a wedding or saving to buy a house, a TFSA may be your best bet. While you can borrow up to $25k from your RRSP to put towards your first home, you will have to pay that money back within 15 years.
Able to afford saving, but have trouble keeping your hand out of the cookie jar? It may be best to store your money in an RRSP, protecting your savings from falling victim to impulse purchases.
Things to keep in mind
• Carrying any consumer debt? If the interest on your debt is higher than your investment/savings returns, focus on paying that off before starting your savings.
• Does your employer have an RRSP matching program? Take advantage of that before anything else. Free money is the best kind of money!
• If you’re able to, save for retirement using your TFSA in addition to your RRSP. Your TFSA allows you to supplement your retirement income, without impacting your tax rate.
Every one of us is obviously in a unique situation, and these guidelines won’t apply for everybody. If you’re still unsure of whether a TFSA or RRSP is better for you, we can connect you with a trusted advisor to discuss your goals, and the best ways to reach them. Deciding between an RRSP and TFSA doesn’t need to leave you spitting out other 4-letter words, and we’ll help make it an easier choice.
Ready to get started? Visit goals.manulife.com to begin your path towards a comfortable financial future.
Please talk to your advisor before making any financial decisions. The commentary in this blog is for general information only and should not be considered tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation.