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RRSPs vs TFSAs – 5 considerations to maximize your savings

by UFile Team Équipe ImpôtExpert | Feb 19, 2020   Comments:

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It’s the age-old tax planning question: should I invest in my RRSP or my TFSA? The answer to this as to any other tax question is that it depends. Don’t worry, this article won’t be another comparative of the differences between these two programs. It will simply ask 5 questions that you should consider before you make a choice.

How soon do you need the money?

When deciding between an RRSP and a TFSA contribution, one of the first things to consider is when you will need the money you’re placing. Are you saving up for an upcoming purchase? Or do you have a longer-term aspiration for this money? The answers to these questions will go a long way toward deciding which plan you should prioritize.

If you have a short timeframe for the money contributed, such as plans to buy a car for example, then the best option is the TFSA. The reason for this is that you can withdraw the money free of tax at any time.

I can see your virtual, critical “eyes” looking at me right now as if to say, “Yeah, that’s great, but a TFSA doesn't get me a tax deduction like an RRSP does!” That’s true, but remember that any withdrawal from an RRSP is taxable income when you withdraw it. If your timeframe for the money is 3-5 years, then getting an immediate tax reduction only to have to pay it back a few short years later defeats the purpose of the RRSP. Keep in mind that the RRSP is a tax-deferred plan, and this means that you will pay tax on your withdrawals eventually. Therefore, you want to delay that expense as long as possible and stretch out the tax reduction as well.

To sum up: short timeframe, TFSA; long timeframe, RRSP.

What tax bracket are you in?

This is purely a dollars and cents consideration. When choosing between an RRSP and a TFSA contribution, the tax bracket you are in will be decisive. The higher the tax bracket, the more beneficial RRSP contributions become. If you find yourself in the first bracket, which has a tax rate of 15%, the TFSA is the best bet. In any other bracket (tax rate of 20.5% and up), the RRSP becomes more appealing.

The reason why RRSPs become more appealing as your income grows is beyond the immediate tax savings on your contributions. There’s also the future tax savings when you withdraw. When you are in retirement, you will be required to pull out of your RRSPs (they become RRIFs at age 71). By that time, your children should be out on their own (they better be!) and your house should be paid off (hopefully!), so your biggest expenses will be gone. You will be living on less income than when you were working, and with lower income, you will be paying less tax during retirement than while in the workforce. Therefore, your tax reduction from your contribution should be more than the tax payable when you will withdraw it during your retirement. Let’s see an example to illustrate this point:

Jane was making $120,000 per year during her peak RRSP contribution period. Back then, she contributed $10,000 a year. At that income level, Jane would get a tax reduction of $2,600 federally (26% tax bracket).

Jane is now retired, she’s an empty nester, her house is paid off, and she can now live on 70% of her peak earnings ($120,000 X 70% = $84,000). At that income level, the biggest tax rate she will pay on income will be 20.5% so her tax payable would be $2,050. Jane now saves 5.5%, or $550, on the withdrawal of that original $10,000 she contributed.

For RRSPs, this is what I would call the icing on the cake! RRSPs reward you throughout your lifecycle starting with an immediate tax reduction when you contribute, then tax sheltered gains during your working years, and a reduced tax rate when you withdraw.

Can you get free money for contributing?

Did I say free money? Absolutely! Some employers kick back additional RRSP contributions for every dollar you contribute to the workplace plan. For example, you'll put in a certain percentage of your wage and your employer will match your contribution. This benefit is given to you free of tax. The only downside is that your RRSP limit is reduced by the amount that your employer contributes to your plan. Still, you rarely see employers offer this type of setup with TFSAs.

So, if your employer is willing to top up your RRSP contributions, please oblige them and take the free money! All other factors in this article become irrelevant.

Are you a low-income earner who is close to retirement?

In this case, the TFSA wins hands down. There’s a specific reason for this: your withdrawals are tax-free and won’t affect other benefits to which you might be eligible, such as the Guaranteed Income Supplement (GIS). The GIS is a tax-free benefit paid to taxpayers 65 and over whose income is below a certain threshold. The benefit is reduced as your income gets closer to this threshold, then eliminated when you exceed it (https://www.canada.ca/en/services/benefits/publicpensions/cpp/old-age-security/payments/tab1-1.html).

 As mentioned earlier, your withdrawals from an RRSP will be taxable. This will reduce this tax-free benefit, or even worse, it might put you over the threshold and make you ineligible. You won’t have this problem if you withdraw from a TFSA instead.

The lesson: if the government is willing to give you free money, do whatever you can to get it.  

Are you planning to buy your first home?

This is where an RRSP withdrawal is similar to a TFSA. The Home Buyer’s Plan (HBP) allows you to borrow from your RRSP to put a down payment on the purchase of your first home. The withdrawal out of your RRSP under the HBP is not taxable, so you get the tax-free withdrawal as with a TFSA but you also benefit from the tax reduction of the RRSP contribution. In this case, the RRSP edges out the TFSA.

There’s a caveat though: as mentioned, this is a loan so you will have to pay back the amount you pulled out of your RRSP. This will be done in 15 instalments starting the second year after the withdrawal by making an RRSP contribution in the required amount. If you fail to make a payment, the instalment will become taxable income on your tax return.

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