Feb 27, 2015 RRSP versus TFSA

by Canadian Cents

Canadian CentsMany people that are saving up for retirement use both a TFSA and an RRSP. While most individuals max out their TFSA contributions first and then forward any extra savings into their RRSP, this may not be the best tax situation for you specifically. The TFSA is a tax-free savings account, which does not tax any capital gains or income earned within the account.  An RRSP is a registered retirement savings plan that uses income deferral and taxes any withdrawals as income. In the following article, we will compare the pros and cons of both accounts:

 

TFSA

The TFSA was only recently introduced to the public in 2009. The advantages of this account are that it provides tax-free earning power, yearly contribution limits that can be carried forward ($5500 as of 2015) and the ability to invest in stocks, fixed income, mutual funds or GICs. Even though the tax-free premise is enticing to most people, there are some downsides to this account. The disadvantages are that it does not carry income deferral ability, no capital losses can be claimed and it has relatively limited contribution amounts. The lack of income deferral means that if you are earning a yearly income and decide to contribute to your TFSA, your tax return will not be adjusted for the amount contributed and you will still have to pay taxes on your entire income. If you earned $20,000 in a year and decided to maximize your TFSA contribution at $5,500, you would still have to pay as if $20,000 was your net income. If you are in a lower tax bracket, a TFSA may make more sense as the lower level of taxation (relative to a high income individual) reduces the benefits of the deferral of taxes.

 

RRSP

The RRSP has been in use in Canada since 1957. The advantages of this account are that it has income deferral ability, a broader investable asset range than the TFSA, and a contribution limit of $24,930, as of 2015, that can be carried forward. The disadvantages are that you must pay income tax on any withdrawals, there is still no ability to claim capital losses, and there is additional tax charged for early withdrawals. Using income deferral can be an asset when you are earning a higher income than what you expect to be earning in your retirement. This allows you to be in a lower tax bracket potentially, which will lower your marginal tax rate, and can normalize the taxes paid over time. If you earned $20,000 and contributed a fraction of the limit, such as $5,500, you would be only taxed on your net income of $14,500. If you plan your retirement savings well and do not require making early withdrawals, the RRSP does have a significant upside but try to save the tax refund as well in order to maximize the savings and take advantage of compounding.

 

It is tough to answer the question on which account is better as the answer largely depends on what is done with any tax refunds, the present level of income vs expected retirement income and what kind of returns you get in the accounts. For younger savers who need the flexibility and face uncertainty with regards to living arrangements/housing, careers and unexpected purchases, a TFSA is likely the better fit. For someone who is more established with a reliable and consistent income and has some typical large purchases such as housing completed, an RRSP is more than likely the way to go. But most important is that the individual is actually saving. It can be a daunting decision with a lot of minutiae that can be confusing and scary to Savers. Regardless of which account you decide to put your hard-earned dollars in, you can be assured that you have already made the most important decision: The decision to efficiently save your money.

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