Planning for the future is critical but, when developing your savings plan, it is important to consider other factors such as your current financial situation and tax planning, as well as your short-term and long-term goals.
There are a number of saving tools available to Canadians, depending on your goals – Registered Retirement Savings Plans (RRSPs), Tax-Free Savings Accounts (TFSAs), Registered Education Plans (RESPs), Registered Disability Savings Plans (RDSP), Pooled Registered Pension Plans, and more.
For those looking to save for retirement, the two most common saving opportunities are TFSAs and RRSPs. For more information on these two specific savings tools, see our blog on understanding the difference between RRSPs and TFSAs.
While the easiest option would be to put the maximum allowable contribution into both your 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?
Over 71
If you are over 71, 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 Unlike money withdrawn from an RRSP or RRIF, contributions will not reduce your taxable income, but you will be able to make tax-free withdrawals.
Registered Pension Plan (RPP) Members
Your annual RRSP contribution maximum is 18% of your previous year’s income. However, 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 the 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More importantly, however, is that once funds are withdrawn from your RRSP, those funds cannot be replaced, and you will have lost that portion of your contribution space, making it harder to save for retirement.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 rules about losing contribution space when you withdraw funds is when you use the Home Buyer's Plan (HBP). The HBP allows you to withdraw up to $25,000 from your RRSP in a single calendar year to build or buy a house.
In this situation, you will not lose the contribution space nor will you have to remit taxes on the withdrawn funds. You will, however, be required to repay the same amount within 15 years. It is also important to note 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 decreases 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 senor 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.
