RRSP or TFSA? Where to put your money

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RRSP or TFSA: Where to Put Your Money?

It’s that time of year again (RRSP season), when people start thinking about putting money into RRSPs.

As the Retirement Savings Plan (RRSP) deadline of March 1, 2018 approaches, I notice that all banks start to question and answer if you have contributed into an RRSP.

When I tell people that I don’t have an RRSP, I usually get looked at like I am crazy. I don’t believe that RRSP’s are the best investment option for everyone, but I do believe that a Tax Free Savings Account (TFSA) is a great tool for everyone.

RRSP is a tax deferral tool, while the TSFA has no tax consequences. What does tax deferral mean?

    If you put money into a RRSP you will get back the taxes on the funds in the year that you contribute. However, when you take the money out, you will have to pay the tax back.

    Example: Assume you contribute $10,000 to your RRSP and are in a 30% tax bracket.

    In Year 1 – Contribution to your RRSP of $10,000 will result in a refund of $3,000 tax

    In Year 2 – Withdrawal from your RRSP of $10,000 will result in tax payable of $3,000

    So basically, the $3,000 is an in and out netting to zero.

The opposite is the case with a TFSA. Contributions in or out of a TFSA do not affect your income or your taxes payable because they are tax free. You only need to be careful with the timing of your contributions. When you take contributions out in one year, you can’t put them back until the following calendar year. The same way contributions in and out of a TFSA are tax free, so are the returns on the funds (whether they are dividends or capital gains). On the contrary, RRSP returns are taxed when they are taken out.

While, both allow you to hold the same types of investments in them (Stocks, GIC, Mutual Funds, Bonds and EFT), I feel that RRSP’s are only useful if they result in tax savings not tax deferral.

The main way RRSP could result in tax savings is if the year you contribute you are in a higher tax bracket than the year you withdraw the funds. Most people plan to take out RRSP funds when they retire and assume that they will be in a lower tax bracket at that time. The reality is that taxes will be higher by the point of retirement; therefore there will be little or no tax savings. Another problem with taking out RRSP’s when you retire, is that it can reduce or eliminate your Old Age Security (OAS) as well as your Guaranteed Income Supplement (GIS) because RRSPs are included to your income when taken out.

Whereas, TFSA withdrawals are not taxable and don’t affect your income. You can have a fully funded TFSA paying you annual income while, still allowing you to collect your OAS & GIS.

There are times when RRSP’s are useful. Again, these are situations when using a RRSP results in a tax savings, which happens if you are in a different tax bracket in one year than you are in another. For example consider the following scenarios:

  • Taking RRSP funds out during a year in which you are on a leave from work. This could be a year while you are on a maternity leave. Funding your RRSP in the years before and removing the funds in the year you are off.
  • When people are planning to make a career change, it is common to have substantially less income during the first few years of the change. Some       career changes may involve going from employment to self-employment. The road to self-employment comes with a high possibility of less income in the first few years.
  • If you are in the high tax bracket and your spouse has no to little income. Contributing RRSP funds into your spouse’s RRSP and receives the tax refund in the current year. Then wait for two preceding calendar years, before having your spouse take out the funds. At this time the funds will be taxed at your spouse’s lower tax bracket.
  • You simply want to take a year off to travel or do other things. I have known people that lost their job and decide to take a bit of time off before going back to work. In this situation, contribute in the year you stop working and take out the funds the following year.
  • If your TFSA is already fully funded and you are the highest tax bracket. Put the amount of funds into a RRSP inorder to reduce your income to a lower tax bracket.

Situations when you should never use RRSP’s:

  • When you are already in the lowest tax bracket. There is no savings to putting funds into a RRSP
  • When you still have room in your TFSA. You should be putting all your extra funds into a TFSA before your RRSP. TFSA’s are more beneficial in the long run.

Example of tax savings:

Example: Assume you contribute $10,000 to your RRSP and are in a 50% tax bracket in the year of contribution and are in 30% tax bracket the following year.

In Year 1 – Contribution to your RRSP of $10,000 will result in a refund of $5,000 tax

In Year 2 – Withdrawal from your RRSP of $10,000 will result in tax payable of $3,000

Resulting in net savings of $2,000.

Most people treat TFSA as a place to hold emergency funds, instead of a vehicle to fund/supplement retirement. You should be using your TFSA to hold equities not GIC’s and savings. Equities pay dividends and have the potential for growth, especially if holding over a period of time.

The RRSP contribution limit is 18% of your gross income to a maximum of $26,230 per year while, the TFSA has a contribution limit $5,500 per year, for everyone over the age of 18 regardless of your income. Currently the total TFSA cumulative contribution limit is $57,500, as of 2018.

Most of the time RRSP’s are not a good choice for people; but in every situation a TFSA is the best option.

Think TFSA over RRSP. If you have not maximized your contribution, I recommend you do so right away!

More information about TFSA

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