For decades, the go-to tax-sheltered savings and investment vehicle has been the registered retirement savings plan. Most Canadians are aware of the importance of making regular contributions to their RRSP.
In 2009, however, a new option was introduced called the Tax-Free Savings Accounts (TFSAs). Since then, we’ve had a choice to better meet short-term and long-term financial objectives. And it’s right about now, close to tax season when Canadians are making the choice between RRSPs and TFSAs.
Are you taking advantage of the maximum allowable contribution to both your TFSA and RRSP every year?
Doing both may not be feasible for many incomes. There simply isn’t enough income to go around. There are also various circumstances that make contributions to one over the other clearly the better choice.
For Canadians over the age of 71, there is no choice. All individual Canadians must collapse their RRSPs by the end of the year in which they turn 71, and no RRSP contributions can be made after that time.
However, taxpayers over the age of 71 can contribute to a TFSA.
Many of those taxpayers, however, have transferred their RRSP savings to a registered retirement income fund (RRIF) and are required to withdraw a specified percentage of funds from that RRIF each year.
If you’re in the fortunate position of having such income in excess of current cash flow needs, that excess can be contributed to a TFSA.
The RRIF withdrawals must still be included in income and taxed in the year of withdrawal but transferring the funds to a TFSA will allow them to continue compounding free of tax and no additional tax will be payable when and if the funds are withdrawn. Additionally, withdrawals in the future from a TFSA will not affect your eligibility for Old Age Security benefits or for the federal age credit.
For those of you who are members of registered pension plans (RPPs) may also find the savings through a TFSA are better or perhaps the only option.
The maximum amount which can be contributed to an RRSP in a given year is generally 18% of the previous year’s income. However, any allowable contribution is reduced, for members of RPPs, by the amount of benefits accrued during the year under their pension plan. If the RPP is a generous one, RRSP contribution room may be minimal, or even non-existent, and a TFSA contribution is the only logical alternative.
Younger Canadians whose savings goals are more short-term typically benefit more from contributing to a TFSA.
Where savings are being accumulated for an expenditure which is likely to occur within the next five years the TFSA is clearly the better choice.
If you’ve been in that situation, you’ve likely thought about making an RRSP contribution instead to get a tax refund, and then to withdraw the funds when the planned expenditure is to be made. However, while choosing that option will provide a deduction on this year’s return, a tax refund will still have to be paid when the funds are withdrawn from the RRSP a year or two later. From a long-term point of view, using an RRSP in this way will eventually erode one’s ability to save for retirement, as RRSP contributions which are withdrawn from the plan cannot be replaced. This can really make a difference when compounding the loss over 25, 30, or more years.
The greatest tax benefit of contributing to an RRSP is when both income and tax payable is high and the intention is to withdraw those funds when both income and the rate of tax payable on that income is lower. If that’s not the case in your situation, saving through a TFSA can make more sense.
If you’re expecting your income to rise significantly within a few years, you can save some tax by contributing to a TFSA while income is still low. This allows the funds to compound on a tax-free basis and then withdrawing the funds tax-free once the income is higher and your tax rate will have increased. At that time, the withdrawn funds can be used to make an RRSP contribution, which will be deducted against income which would be taxed at the much higher rate, generating a tax savings. And, if a need for funds should arise in the meantime, a tax-free TFSA withdrawal can always be made.
In the case of lower incomes, where there isn’t likely to be a great difference between pre- and post-retirement income, you’re better off saving through a TFSA. That’s especially the case if you’re eligible in retirement for means-tested government benefits like the Guaranteed Income Supplement or tax credits like the GST credit or age credit.
Withdrawals made from an RRSP during retirement will be included in income for purposes of determining eligibility for such benefits or credits, and lower-income taxpayers could find that an RRSP withdrawal has pushed their income to a level which reduces or eliminates their eligibility.
Withdrawals from a TFSA are not included in income for the purpose of determining eligibility for any government benefits or tax credits, so saving through a TFSA will ensure that benefits are not at risk.
If you’re torn between RRSPs and TFSAs, we encourage you to give us a call. By looking at your specific goals and situation, Kerr and Company, Kelowna accounting services, can determine the best strategy. Contact us today.