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Tax Matters

RRSP vs. TFSA: Tim Cestnick on where to put spare dollars Add to ...

It’s an age-old debate: Which came first, the chicken or the egg? As important as it might seem to debate this issue, I have to ask the question: Will the answer change how you make your western omelette tomorrow morning? Let’s end the debate. I’m starting a petition today to stop this ludicrous discussion.

A more recent debate, however, is worth talking about. I’m referring to the question: Which comes first, your registered retirement savings plan (RRSP) or tax free savings account (TFSA)? Millions of Canadians are considering contributions to their RRSPs before the Feb. 29 deadline, and many are wondering whether an RRSP or TFSA is a better bet.

The basics

My aim today is not to run through the many rules around these plans. But as a refresher, here are the basics: There are limits to how much you can contribute to RRSPs and TFSAs alike. You’ll find your RRSP contribution limit on your Notice of Assessment that you received after filing your tax return last year. As for your TFSA, you can contribute $5,000 annually and have been able to do so since 2009 (for total contribution room of $20,000 in 2012 if you haven’t made any contributions to a TFSA yet).

You can deduct contributions to your RRSP, but not to your TFSA. On the flip side, withdrawals from your RRSP are taxable but withdrawals from a TFSA are tax-free. To the extent you make a withdrawal from a TFSA you can re-contribute that amount starting in the following calendar year. RRSPs don’t allow re-contributions. Both RRSPs and TFSAs offer tax-free growth of investments inside the plan.

The thinking

Commonly held thinking is that, at its most basic level, the decision between an RRSP and TFSA comes down to your marginal tax rate today and your expected rate in retirement when you start to draw money from the plan. If you expect to have a higher marginal tax rate in retirement than today, then contributions to a TFSA make more sense since you won’t face tax on withdrawals later. If you expect your marginal tax rate to be lower when you retire then an RRSP generally makes more sense.

How does this apply in real life? If you’re a lower-income individual, perhaps because you’re younger and in an earlier stage of your career (perhaps a student), or you’re on parental leave or on sabbatical, and you expect to earn a higher income in the future, you’re a good candidate for a TFSA contribution. Further, your RRSP deduction won’t save you as much tax today as it might later, so contribution to an RRSP later may make the most sense if you can’t contribute to both plans today (you can always contribute to your RRSP and save the deduction for a future year if you have the means to contribute to both).

If you receive income-tested benefits such as Old Age Security, the Guaranteed Income Supplement, child tax benefits, or GST credits, withdrawals from a TFSA won’t affect your income and therefore will preserve your benefits. Withdrawals from an RRSP will impact these benefits, so a TFSA may be a good option here.

The nuances

Other than considering your marginal tax rate, there are other things to think about when contemplating an RRSP or TFSA. TFSAs may be more appealing to seniors since there is no age limit for contributions. Also, if you’re expecting “supernormal” rates of return on an investment, a TFSA will be appealing because you won’t face tax on the disposition and withdrawal of those funds. TFSAs are also appealing if you aren’t going to need the funds in the plan since you’re not required to make withdrawals, unlike an RRSP which matures at the end of the year in which you reach age 71. The assets in a TFSA can also be used as collateral on a loan (not so with RRSP assets). Finally, if you’re saving for short-term consumption then TFSAs offer greater flexibility.

RRSPs offer a psychological advantage in that many people are hesitant to make withdrawals due to the tax that will apply, which could result in greater savings. It’s also generally possible to contribute more to an RRSP than a TFSA. Confused? The fact is, both plans are effective. Most Canadians should have both, and the plan you contribute to may change from time to time depending on your income or purpose for saving. With RRSP season here, many will put thousands into their RRSP, and that’s all good.

Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians. tcestnick@waterstreet.ca

For tips, stories, videos and live chats ahead of this year's RRSP contribution deadline, check the Globe Investor 2012 RRSP season section for daily updates.

 
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