One of the most common questions many people is whether they should contribute to their Registered Retirement Savings Plan (RRSP) or Tax Free Savings Account (TFSA).
About half of Canadians have a TFSA, but only one in ten people are able to correctly name investments eligible for a TFSA.
Here are the main differences between an RRSP and a TFSA.
Differences between the TFSA and RRSP
|Growth||Uses post-tax dollars||Uses pre-tax dollars|
|Age Requirements||Must be 18 years old||Can be opened at any age (up to 71) as long as there is contribution room|
|Withdrawals||Not taxed||Taxed in the year of withdrawal|
|Contribution limit||Currently $10,000 annually||Currently $24,930 (2015) and depending on contribution room|
|OAS Clawback||Withdrawals don’t affect the OAS clawback||Withdrawals may trigger the OAS clawback|
|Tax deductibility||Contributions arent deductible||Contributions are deductible|
|When Account Holder Passes Away||Transfers to beneficiary (ie. Spouse) and after they pass away only the increases in value after that point are taxable||Transfers to beneficiary (ie. Spouse) and after they pass away the entire RRSP becomes taxable|
|Advantageous When….||Current marginal tax rate is lower than it will be when you retire||Current marginal tax rate is higher than when you retire|
|Contribution Room||Can be carried forward||Can be carried forward|
|Over-contribution Penalty||1% per month||1% per month (over $2,000)|
|Tax consequences at age 71||No tax consequences||RRSP must be converted to RRIF (or annuity) and minimum withdrawals begin|
|Earned Income||Not required for a contribution||Required to create contribution room|
|Blue chip pension?||Preferred option (allows for tax-free withdrawals)||Not the preferred option (withdrawals are taxable, can trigger OAS clawback)|
|Emergency Fund Savings?||Preferred option (flexibility on withdrawals)||Not the preferred option (withdrawals are taxable)|
The Decision Depends on Your Own Personal Situation
Choosing between a TFSA or RRSP essentially depends on your marginal tax rate now and when you withdraw the cash. For most people this is when they retire.
Students who have a lower income now (less than $42,000) but expect to have a higher income in the future (before they retire) should contribute to a TFSA because they would already be in a low tax bracket. Since the goal of an RRSP contribution is to lower the taxes paid by lowering the tax bracket this would defeat the purpose. Assuming an annual income of $70,000 or higher when the cash is withdrawn (retirement) a TFSA makes even more sense because of the OAS clawback on retirement income.
High school students with part time jobs only have the option of the RRSP because a TFSA can only be opened by someone over the age of 18. The tax deduction can be deferred until he/she is working full-time and earning a higher income.
Those in a higher tax bracket (income over $138,000) who expect to have a lower income when they retire should contribute to an RRSP because the taxes saved when the contribution is made (higher tax rate) are bigger than the taxes on withdrawal (lower rate).
Recent studies have been done analyzing the two options and have shown that the after-tax rate of return is higher for RRSP contributions only when the marginal tax rate is lower on retirement. If the marginal tax rate on retirement is higher, then a TFSA contribution makes more sense.
To complicate things, there is an extra tax on retirement income higher than $72,809 (2015 rates) called the OAS clawback. Withdrawals from an RRSP are added to this calculation but withdrawals from a TFSA are not.
Regardless of your income, deciding whether to contribute to a TFSA or RRSP boils down to tax rates: will your tax rate increase when the withdrawals are made compared to now? If so, you should probably contribute to a TFSA. If your tax rate will decrease when the withdrawals are made compared to now, you should probably contribute to your RRSP.
That being said, any effective retirement plan uses a combination of both RRSP and TFSA – they’re not mutually exclusive, so having both means you’ll be able to take advantage of the tax deferral benefits of an RRSP as well as the tax-free withdrawals of a TFSA.
Conclusion: For most people, their income on retirement will be slightly less than when they were working. In this case it makes sense to contribute to an RRSP to maximize the tax savings. People should remember not to neglect a TFSA completely though even if an RRSP contribution makes more sense due to the OAS clawback.
Related: Will Your TFSA Be Audited?