When it comes to retirement savings, you’ve likely come across the question “TFSA or RRSP?”. Deciding which registered investment type is best for you isn’t a matter of determining which is fundamentally better, but of understanding which will best suit your current and anticipated future marginal income tax rate and your short and long-term savings goals. The real question is ‘which one will best facilitate my goals?’
Tax-Free Savings Accounts
Like an RRSP, a TFSA is a personal savings account which accommodates growth by sheltering your investment returns from tax. Unlike RRSPs, which have been around since the 1950s, TFSAs are relatively new. They were introduced in Canada in 2008 and are currently used by approximately 50% of Canadians.
TFSAs can be invested in a wide variety of investments and can be easily accessible. There are no penalties for withdrawing from your TFSA and when you do so, you aren’t required to pay income tax. These factors make TFSAs an attractive option for emergency and short-term savings (think down-payment on a property or planning a wedding).
When it comes to long-term retirement savings, TFSAs are also an excellent investment option for individuals who expect to be at a higher marginal tax rate when they withdraw their money compared to when they initially invested it. Simply put, if you begin investing while in a 25% marginal tax bracket, for example, and eventually withdraw retirement savings while in a 40% marginal tax bracket, a TFSA will allow you to avoid having to pay 40% taxes.
While not designed for a specific age group, TFSAs are often a solid choice for younger individuals just starting their careers who likely have short- and mid-term financial goals as well as retirement savings goals. Also, they expect to be more established and making a higher income in 10 to 20 years when they can take advantage of the tax benefits of an RRSP.
Registered Retirement Savings Plans
Canadians tend to be more familiar with (and, in some ways, trusting of) RRSPs because of how much longer they have been around. While this is a valid attitude, each investor’s needs are different and the appropriateness of RRSPs as part of your retirement savings initiatives, should be determined as part of building your full financial plan with your advisor.
Unlike TFSAs, yearly individual RRSP contributions – those made with “after tax dollars” – are typically accompanied by an upfront tax benefit, like a tax refund.
Group RRSP plans offered by some employers differ slightly in that they contribute “before tax dollars” – deducted from an employee’s paycheck – directly into an RRSP. The advantage of this situation is that you don’t have to wait for a refund and more of your contribution dollars are working for you sooner.
In theory, people who choose to hold retirement savings in an RRSP will likely be in a lower tax bracket during their retirement years than the one they occupied while working. When the time comes to begin taking a retirement income, it would be better to do so while in a 30% tax bracket than the 40 to 50% bracket you were in at the height of your working career.
When Two is Better than One
A common misconception about TFSAs and RRSPs is the idea investors must pick one. Remember, life is unpredictable and your financial situation when you begin investing will most likely change throughout the years until you’re ready to retire. With this need for flexibility in mind, know that there are numerous ways of strategically incorporating both TFSAs and RRSPs into your financial plan. Many people don’t know they can flip their TFSA, with no tax consequences, into an RRSP when it makes most financial sense.
Similarly, it is common practice to buy an RRSP as a method of offsetting tax debt. Instead of paying the Canada Revenue Agency directly and saying goodbye to your money, transferring savings from a TFSA into an RRSP account could allow you to retain your money as eventual retirement income while still “paying” the CRA by giving them the opportunity to put your tax benefit towards some or all of your outstanding debt.
For help determining how a TFSA and/or an RRSP will best suit your financial goals and retirement needs, connect with us.