While it may not be the first thing that comes to mind when we ask ourselves what we want to do with our discretionary income, contributing to saving plans is critical to an enjoyable retirement.
The deadline for 2017 Registered Retirement Savings Plan (RRSP) contribution is March 1, 2018, which means many of us are dealing with the annual decision of whether we should put our savings into an RRSP or a Tax-Free Savings Account (TFSA).
While the easiest option would be to put the maximum allowable contribution to both our TFSA and RRSP, this is not possible for many Canadians, as it requires a substantial amount of discretionary income.
So, which do you choose – your TFSA, your RRSP or a clever combination for both?
RRSPs
Registered Retirement Savings Plans were specifically designed with long term savings in mind. When you contribute to your RRSP, you are able to reduce your taxable income in the year that the contribution was made, reducing your tax owing.
When you withdraw those funds, usually after retirement when income has been substantially reduced, you will be taxed on your withdrawals.
Each year you are allowed to contribute a percentage of your previous year’s income to your RRSP, up to a specified maximum.
In 2017, you could contribute 18% of your 2016 income, up to a maximum of $26,010 (18% of $144,500). Unlike other tax saving tools, RRSP contributions canbe made until March 1 of the following year (e.g. you can deduct contributions from your 2017 income tax return so long as they are made by Thursday, March 1, 2018).
If you do not contribute the full amount in any given year, it is carried forward indefinitely.
The contribution limit for 2018 in 18% of your income up to a maximum of $26,230 (18% of $145,725).
TFSAs
Tax Free Savings Accounts operate in reverse of an RRSP. While the money you deposit into your TFSA is taxed on the current years return, when you withdraw the funds, you do not have to pay taxes, even if the withdrawal includes interest earned.
In terms of filing your taxes, there is no deadline for when contributions must made, as TFSA contributions will not affect the outcome of your current years tax return. There is however, an annual limit of $5,500 for both 2017 and 2018.
Like an RRSP, any contribution room that remains unused will be carried forward. Unlike an RRSP, if you make a withdrawal from your TFSA, you can re-contribute the same amount in the following year.
This can create complications when trying to keep track of your allotted contribution amount, however, information of both your TFSA and RRSP can be found on your Canada Revenue Agency (CRA)- My Account or by contacting the CRA directly.
Choosing Between a TFSA and RRSP
Now that we have discussed the basics of TFSAs and RRSPs, it is time to talk about common situations and which tool can be most beneficial.
71 years of age or Over
If you are over 71 years of age, your RRSP has been collapsed and you can no longer make contributions. As a result, if you are still putting away money for a rainy day, your TFSA is the only tax-sheltered savings option available. Unlike money withdrawn from an RRSP or RRIF, contributions will not reduce your taxable income, but you will be able to make tax-free withdrawals.
Generous Registered Pension Plan (RPP) Members
As mentioned above, your annual RRSP contribution maximum is 18% of your previous years income. What we did not mention, and is specific to taxpayers in this situation, is that this maximum is reduced by amounts accrued, in the current year, under your RPP. If you’re RPP is substantial, your RRSP contribution room may be reduced or non-existent.
As a result, a TFSA may be the best, if not only option.
Short Term vs. Long Term Goals
If, like many young Canadians, you find yourself considering short-term goals (i.e. buying a car, getting married, etc.) that will likely come to fruition in the next five years, your TFSA is most likely the best option.
The reason is twofold. Firstly, while you can withdraw money at any time from your RRSP, withdrawals are taxable, increasing your tax owing during the year of withdrawals. While this is offset by tax savings in the year of contribution, increases in income within that five-year period, could result in a greater amount of tax paid in the long run.
More importantly, however, is that once funds are withdrawn from your RRSP, those funds cannot be replaced, and you will have lost that portion of your contribution space, making it harder to save for retirement.
TFSAs on the other hand, offer tax free withdrawals (without a tax benefit in the year of contribution) and you can replace any amounts that have been withdrawn in the following year.
Buying a House
One exception to the above guideline is buying a house. This is because RRSPs offers a Home Buyer’s Plan (HBP) which allows you to withdraw up to $25,000 in a single calendar year to build or buy a house.
In this situation, you will not lose the contribution space, but you will be required to repay the same amount in a specified period of time. It is also important to consider that these repayments will not reduce your taxable income in the year that they are repaid.
High Income Now, Low Income Later
If your income is high and you are planning to withdraw your savings when your income has decreased (e.g. retirement) then an RRSP will likely offer you the greatest tax benefit.
This is because RRSP contribution decrease your taxable income in the year that they are made, deferring tax payment until you withdraw the income from your RRSP.
Once you retire, you can begin withdrawing these funds at a lower tax bracket, in most situations.
Low Income Now, High Income Later
In contrast to the above example, some taxpayers, such as students, may have low income with an expectation of increased income in the future (i.e. once they graduate or make a career change). In this situation, contributing to a TFSA while income is low will allow funds to earn interest tax-free.
Once you begin making more money you can redirect your savings toward an RRSP. At this time, you can either leave your savings in a TFSA, in case funds are needed in the short term, or you can move them to an RRSP for additional tax savings in the year of contribution.
Low Income Now, Low Income Later
For those who expect to remain in a low-income tax bracket before and during retirement, TFSAs can be a beneficial tool, especially if you will be eligible for benefits such as the Guaranteed Income Supplement or tax credits for senior taxpayers and those with low income (i.e. age amount, sales tax credit, etc.).
This is because RRSPs withdrawals, during retirement, are included in taxable income when determining eligibility for such benefits. As a result, RRSP withdrawals could reduce, or even eliminate, the amount you would have otherwise been eligible for. This is not the case with TFSAs.
It is important to remember that these are just a few of the many factors that need to be considered when deciding between a TFSA or RRSP. To find out which option works best for your specific situation, contact us today. We look forward to helping you plan and minimize taxes throughout your lifetime.
