RRSP or TFSA – Which should I contribute to?

RRSP or TFSA – Which should I contribute to?  We get this question a lot – especially at this time of year, with the new TFSA dollar limit kicking-in on January 1st and as the March 1st deadline approaches for making an RRSP contribution. 

First, what’s the difference between an RRSP (Registered Retirement Savings Plan) and a TFSA (Tax-Free Savings Account)?

An RRSP is an investment account registered with the Canada Revenue Agency whereby any contributions you make to it, and any growth of those contributions, is tax-sheltered until the moment you withdraw funds.  At time of withdrawal, 100% of the withdrawn amount is counted as taxable income.  Ideally, since this money is intended for retirement, withdrawals are made when you are retired or no longer making a working income and are presumably subject to a lower marginal tax rate than during your working career.

You also receive tax deductions based on the amount of contributions you make and your marginal tax rate (more on that below). Contributions can be made annually up to a calculated personal contribution limit, and any unused contribution room is carried forward.  By the end of the calendar year you turn 71, your RRSP is considered to have matured and must either be withdrawn or converted to an annuity or RRIF (Registered Retirement Income Fund), two investment vehicles that can provide you with a flow of retirement income.

A TFSA, on the other hand, is an investment vehicle which can last for life, in which contributions and growth are not taxed at any time. They simply return to you tax-free funds at the time of withdrawal – regardless of whether you are withdrawing capital, capital gains, dividends or interest.  The Canadian federal government determines the TFSA dollar limit for each year.  A TFSA can be a great source of tax-free income in retirement, and perhaps even more importantly, it can be an estate planning tool that allows for the transfer of wealth to your beneficiaries tax-free.

One potential advantage of contributing to an RRSP over a TFSA is that with the former, you receive a tax deduction based on the amount of your contribution - the deduction is calculated by multiplying your contribution by your marginal tax rate.  I used the word “potential” because people in higher tax brackets will be able to reduce their tax bills to a greater extent than those in lower tax brackets. Consider this comparison:

1. Ontario resident A has taxable income of $120,000, which makes her marginal tax rate 43.41%.  If she contributes $10,000 to her RRSP, she can expect to reduce her tax liability by $4,341.
2. Ontario resident B has taxable income of $60,000, which has a marginal rate of 29.65%.  With the same $10,000 RRSP contribution, she is reducing her tax liability by $2,965.

And so, if you are in a lower tax bracket like resident B, you may consider contributing to your TFSA instead of your RRSP to grow your investments tax-free because the tax savings you will receive from the TFSA may outweigh that which the RRSP will provide.  It depends on your specific circumstances, something we would be pleased to discuss with you.

Then, if you enter a higher tax bracket and need cash for RRSP contributions, funds can be withdrawn from your TFSA, tax-free, for this purpose.  Now that you have contributed to the RRSP, you have the benefit of the short-term tax savings at your higher income level, and you have the ability to replace the funds in your TFSA to gain back the long-term tax benefits.

Some other details to keep in mind:

• We generally recommend leaving your TFSA as a source of tax-free retirement income or as an estate planning tool. For retirees, withdrawn funds are totally tax-free source of income.  As an estate tool, your beneficiaries receive your assets completely tax-free.
• Any individual that is a resident of Canada who has a valid SIN and who is at least 18 years old is eligible to open a TFSA.  If you have not yet contributed to a TFSA or have not used up all your contribution room, you still can. Specifically, if you were 18 or older in 2009, your TFSA contribution room grows each year, even if you do not file an income tax and benefit return or open a TFSA. If you turned 18 after 2009, your TFSA contribution room starts in the year you turned 18 and accumulates every year thereafter.
• Unlike RRSPs, TFSAs are not recognized in the United States, so any US income would be subject to withholding tax, which hinders the tax-free benefit of the TFSA.  You will want to keep this in mind when choosing to hold US securities in your TFSA.  In an RRSP, US income is tax-sheltered.

Want to learn more?  Our vision is an investing world that is far less mysterious, with far fewer and far less complicated products. So, we are totally committed to making things easy to understand – and to listening and learning about you.  Just reach out through Contact Us or give me a call at 416 928 9602.

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PS click here for a one-page reminder of contribution limits and other details for RRSPs, TFSAs and RESPs.