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Question from The Globe’s GenYmoney Facebook group: “Is it better to max out your TFSA contributions before contributing to an RRSP? My income is higher than what I expect to need during retirement, so RRSPs make sense. But I expect my income to grow, and so I feel like the deductions will be better used in the future, after I no longer have room to contribute to a TFSA.”
Ms. Simmons work with young people to help them navigate the new economic climate with personal finance, ethical investing and small business advice.
Shannon Lee Simmons is a financial planner and founder of The New School of Finance in Toronto.
Answer: When choosing between an RRSP or a TFSA, and depending on your age, it’s helpful to think about what your goal is before comparing the tax savings.
First off, what exactly is a Registered Retirement Savings Plan (RRSP)? An RRSP is a type of account that you can save in. You can hold cash, GICs, mutual funds, index funds, ETFs and more. An RRSP is tax sheltered and contributions count as a tax deduction. There’s a big difference between the two.
A tax deduction means that the money you put into your RRSP is deducted from your income at tax time. So, you pay less tax in that year. For example, if you make $50,000 a year and put $5,000 into your RRSP, you’ll pay tax on $45,000 instead of $50,000. If you’re an employee, this likely means a refund because your company deducted the tax you pay on an income of $50,000. If you’re self-employed, this means you owe less tax than you would without the deduction.
There is a ceiling on annual RRSP contributions (depending on your income) that qualify for the tax deduction, but unused contribution room from previous years can be used.
A tax shelter means that you don’t pay tax on the income earned inside the account. For example, if you put $1,000 into a tax shelter, and you got 2-per-cent interest, you’d get $20 tax-free. If your money was held in an account that was not a tax shelter, then you’d pay tax on the $20 that you earned.
Okay, so what’s a TFSA (Tax-Free Savings Account)? The TFSA is also a savings account. It can also hold cash, GICs, mutual funds, index funds, ETFs, etc. And it’s not just for high-interest savings – it can also be a heavy-duty investment account. But while the TFSA is a tax shelter, it has no tax deduction.
Since an RRSP is a tax shelter and has a tax deduction, you’re probably thinking that this makes the RRSP superior to the TFSA. But it really depends on your goals and your timing.
The downside of the RRSP is that once the money goes into the RRSP, it should likely stay there until retirement. When you take money out of the RRSP, it’s added back into your income for that year, unless you want to use the money in your RRSP for the Home Buyers’ Plan, which can be used by first-time buyers only (up to $25,000) or the Lifelong Learning Plan ($20,000).
On the other hand, if the $5,000 you put into your TFSA grew to $6,000 and you wanted to take out the $6,000 for anything at all, (house, wedding, business, whatever), you’d pay no tax. This feature means the TFSA allows for much more flexibility on what you want to do with your money.
So, think about what you are saving for. I would hate for you to put all your money into the RRSP for the tax deduction, have a fat RRSP and then want to use that money for anything other than your first home or full-time school.
To answer your question about saving the RRSP contribution room for the future. Yes, this is also a great strategy if you’re sure your income will go up. You can save in the TFSA in the meantime, tax-sheltered, and then down the road, contribute into the RRSP to take advantage of tax savings in the future.
Still not sure which to choose? Obviously both is best, but if you can't do both, here's a handy RRSP vs. TFSA quiz
1. Are you saving for a house (and you are first-time home buyer) or to go to full-time school?
YES – go to question 2
NO – go to question 3
2. Do you already have $25,000 saved towards down payment or $20,000 towards school already saved in RRSP?
YES – be careful, everything you put into RRSP at this point above those amounts can’t be withdrawn without the tax becoming due that year. Be sure to check your contribution room. You should save for the rest of your down payment or school payments in a TFSA so you can access them. Watch TFSA contribution room.
NO – You can likely utilize the RRSP up to these limits to get the tax savings and still be able to use the money to meet your goals. Watch RRSP contribution room.
3. Do you have financial goals that require savings before retirement?
YES – Be careful how much you put into the RRSP. You won’t be able to pull it out without paying tax now. The TFSA may be the best bet to get tax sheltering and to be able to use the money. Watch TFSA contribution room.
NO – Really? You’re not saving for anything between now and retirement? Okay, go to question 4.
4. Are you in one of the lower marginal tax brackets? Find out HERE
YES – the TFSA could be the best place for you to save now so you can take advantage of the RRSP tax deduction later on in life when you earn more money and your income tax bracket is higher. Watch the TFSA contribution room.
NO – So, you’re likely in a higher tax bracket. The tax savings from the RRSP could be really helpful for you to save taxes now while you’re in your peak earnings and then withdraw the funds at a lower tax bracket in retirement. Watch the contribution room.
Keep in mind as well, if there’s matching in a company RRSP or TFSA, that trumps all the things. Free money is free money. Max out those work plans to get as much free money you can.
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