TFSA or RRSP -- What Makes the Most “Cents” for You?
One of the most common questions I get asked is, which is better... a TFSA or RRSP? I usually answer with, well...that depends. I know...super helpful right? Choosing which one to invest in may sound overwhelming and complex, but it’s easier than you might think. Let’s un-complex-icate things. First, both are great investment options that shelter taxes on your returns. What does this mean? Well... when the money you put in the TFSA or RRSP stays put, you don’t have to pay taxes on the growth of those investments. But wait, there's a little more to it and depending on your situation, one might give you a better bang for your buck. Here is a quick comparison of the two and some other factors to consider before you choose whether or not a TFSA or RRSP makes the most ‘cents’ for you. Tax Deductions
When you invest your money in a TFSA (tax-free savings account) you don’t get a deduction on your taxes but with an RRSP (registered retirement savings plan) you do. Why is this? It basically comes down to when, not if you pay taxes. Yes, sadly, taxes always need to be paid.
So what difference does timing make?
With a TFSA you have already paid tax on the money that you put in so you can withdraw it at any time without paying additional taxes. With an RRSP you defer paying taxes on the money that you invest now and receive the tax deduction. However, you must pay tax on that amount later when you make a withdrawal. There are two exceptions for penalty-free withdrawals for RRSP’s. These are the home buyers plan (HBP) and the lifelong learning plan (LLP) which you may have heard about, but I won’t go into detail here. Withdrawal Rules
This is another instance where timing is everything. While technically you can withdraw your money at any time from a TFSA or RRSP, there may be some hefty fees if you withdraw from the latter before retirement.
TFSA’s are very flexible in that you can withdraw at any time without penalty or taxes. However, early withdrawals of RRSP’s are not only counted as income and taxed in that year, additionally they are subject to something called withholding tax. The percentages for withholding tax vary depending on the amount withdrawn and can become quite significant. Ideally, withdrawing from your RRSP before retirement should be a last resort after all other avenues have been exhausted.
One more thing to note. When you take money out of a TFSA, you can put it back in later. Essentially you can withdraw and reinvest as many times as you like without penalty but only up to your allowable limit. We will discuss these limits next. However, when you take money out of an RRSP, you cannot put it back in later. That specific amount of contribution room disappears. While you can continue to use new available room, you cannot recontribute the amount that was withdrawn. This reduces the potential value of your RRSP at retirement. Contribution Limits and Penalties for Exceeding Allowable Amounts
You can never have too much of a good thing right... or can you? Both TFSA’s and RRSP’s have limits on how much money you are able to contribute. These annual and lifetime limits vary among individuals and follow specific calculations in determining the amount of available contribution room. How these amounts are calculated is not as important as knowing how much room you have in each. This is very important because if you over-contribute you may be subject to penalties for exceeding the allowable amounts, which can definitely add up in a hurry.
How can I find out what my contribution limits are?
You can find your available contribution room on My Account through the CRA. If you are not familiar with this handy service, I highly recommend that you sign up. I’ll include a link to a video tutorial below on how to register. You can also find your RRSP contribution room directly on your (NOA) notice of assessment. Other Factors to Consider
Here are some other factors to consider before you choose whether a TFSA or RRSP is best suited to you.
How much income do you earn in a year?
A general rule of thumb is, if you earn less than $50k, invest in TFSA's if you earn more invest in RRSP's. The reasoning is that when you are in the lowest tax bracket, deductions are not as beneficial as to someone in a higher tax bracket. Conversely, if you are in a higher tax bracket and postpone those taxes, you end up paying a smaller percentage because your income is almost always less in retirement.
What are your savings goals?
Short term savings are for things you’d like to purchase before retirement. You will want the flexibility to withdraw freely without penalty. So, if you are saving up for that sweet SUP board, your dream PC gaming rig, a long overdue bathroom reno or just an emergency fund, a TFSA is the right choice for you.
RRSP's are designed for long-term investments and ideally not withdrawn until after retirement.
An exception to this rule is to utilize the tax free ability to withdraw from your RRSP utilizing the home buyers plan (HBP) to purchase a house or the lifelong learning plan (LLP) to head back to school.
Does your employer offer a group RRSP or matching contributions?
Group plans are almost always your best investment choice. If you are fortunate enough to have a matching program, you get an automatic return on your investment and that’s pretty tough to beat anywhere else.
I hope this guide has made some "cents” for you. Please leave any questions or comments below. I would love to hear from you.
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CRA My Account registration video tutorial.
Cheers and Happy Investing!