RRSP or TFSA – Which Savings Plan is Best for You?

What are RRSPs? What are TFSAs? How are they different? What are the advantages of RRSPs and the advantages TFSAs? Which is best fit for your savings plan? Registered Retirement Savings Plans (RRSP) and Tax Free Savings Accounts (TFSA) are both good ways to save and allow Canadians to invest in a variety of funds including guaranteed investment certificates (GICs), mutual funds, stocks and bonds. However, they are subject to very different tax treatment.

RRSP

The annual deduction limit for RRSPs, also known as contribution room, is 18 % of your previous year’s income as reported on your tax return, to a maximum of $23,820.00 for 2013. This limit will be reduced if you contribute to a registered pension plan through your employer. The deadline for RRSP contributions is March 1st of each year and any unused contribution room is carried forward to subsequent years. For example, if your current deduction limit is $7,000.00 and you contribute $5,000.00 on or before March 1st, then the remaining $2,000.00 of your limit is carried forward and added to your future deduction limit. You are notified of your RRSP contribution room by Canada Revenue Agency (CRA) on your annual notice of assessment.

The amount of your RRSP contribution can be deducted from your taxable income, which reduces your income tax payable and may result in a tax refund. This refund can be used at your discretion, but it is highly recommended that it be used to help improve your financial situation or further enhance your retirement fund. For example, if you borrowed money to contribute to a RRSP, you should always use your tax refund to pay down that loan. If you did not have to borrow to contribute to a RRSP, then you could use your tax refund to help fund next year’s RRSP contribution. This approach will maximize the effectiveness of the RRSP.

There is one very important aspect of RRSPs that must be emphasized. When you eventually draw out money from your RRSP, those funds are taxable and will be added to your taxable income in that year. RRSPs are a tax shelter designed to encourage and assist in retirement savings.

Therefore, it is strongly advised to never cancel or draw out money from such a plan until retirement, unless absolutely necessary. To do so will have negative and irreversible consequences. First of all, you will have reduced the funds available to you for retirement. Secondly, you will have lost any future potential earnings, such as interest and dividends, on those funds. Thirdly, and perhaps most significant of all, the funds that you draw out must be added to your employment and other earnings during the year involved, and thus will be subject to a higher tax rate.

CRA does allow the temporary use of RRSP funds without being subject to tax, for new home buyers and for educational purposes. In these cases, the funds must be repaid within a designated time period.

Advantage of an RRSP

The main advantage of RRSPs is the ability to deduct your contributions from your taxable income while you are employed and in a higher income tax bracket. Upon retirement, you are generally in a lower income tax bracket, and therefore when you draw out your RRSP funds, they will be taxed at the lower rate. If you wish to have a monthly income from your RRSP, it must be converted to a Retirement Income Fund (RIF) no later than the year you turn 71. You will then receive a monthly annuity which is essentially your personal pension plan. If you choose, you may draw out lump sum amounts from your RRSP, keeping in mind the tax implications.

TFSA

TFSA’s are a relatively new savings vehicle, introduced by the federal government in 2009. They offer an alternative method of savings with tax sheltered earnings. Unlike RRSPs, which are designed primarily for retirement savings, money contributed to a TFSA cannot be deducted from your taxable income. However, the earnings derived from TFSAs, such as interest and dividends, are not subject to tax.

The annual contribution limit to a TFSA is not based on your income and is not affected by any pension plan that you may have through your employer. The annual limit was set at $5,000.00 from 2009 to 2012 but was increased to $5,500.00 for 2013, with further increases anticipated in the future.

Advantage of a TFSA

The major advantage of a TFSA is that funds can be invested and allowed to grow with interest and other earnings, and there are no tax implications to consider, as these are non-taxable savings. Because the original contributions are not deducted from taxable income and the earnings are not subject to income tax, any money drawn out is yours, 100 %.

Which is Best?

Many people want to know which savings plan is best for them. When considering how to plan your savings, the answer really depends on your needs. If your priority is saving for retirement with no short term goals, then the RRSP is probably your best option. If you are focused on shorter term savings, then the TFSA may be utilized with its non-taxable savings. Indeed, if there is a high likelihood that you will need access to your funds long before retirement, the TFSA should be used because the tax implications of a RRSP will definitely work against you.

Of course you can always take advantage of both savings tools. This would require that you divide your available funds between the two. For some, this may be the ideal solution: you have the tax-sheltered deduction of the RRSP for long term retirement savings and the tax-sheltered earnings of a TFSA for short to medium term savings.

Whichever you choose, begin as soon as possible in order to maximize the benefits. Remember, you don’t have to struggle with lump sum contributions. Most financial institutions and investment brokers offer many options, including regular monthly contributions which are tailored to your personal circumstances.

The attitude which has worked for many is “pay yourself too”. Make that monthly contribution as if it were another important obligation, and control your debt. The day will come when you will be glad that you did!

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2 comments to RRSP or TFSA – Which Savings Plan is Best for You?

  • GGiles  says:

    Great article! I feel the RRSP is the better choice based on the encouragement of the penalty to leave the money in there. Thanks for the info!

  • Nauru wczasy  says:

    As I website possessor I believe the content matter here is rattling excellent , appreciate it for your efforts. You should keep it up forever! Best of luck.

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