RRSP vs. TFSA, which is the best solution for you?
Which comes first, your registered retirement savings plan (RRSP) or tax free savings account (TFSA)? With the March 1st deadline looming, many are wondering whether an RRSP or TFSA contribution is the better choice.
There are limits to how much you can contribute to RRSPs and TFSAs alike. Your RRSP contribution limit can be found on your Notice of Assessment that you received from CRA after filing your 2011 tax return. As for your TFSA, you have been able to contribute $5,000 annually from 2009-2012 and this increases to $5,500 in 2013 (for a total contribution room of $25,500 in 2013 if you haven’t made any previous contributions to a TFSA).
Contributions to your RRSP’s are tax deductible, however contributions to TFSA’s are not. Conversely, withdrawals from a TFSA are tax-free, but withdrawals from your RRSP are fully taxable as income. Any withdrawals from a TFSA can be re-contributed the following calendar year. RRSPs however, do not allow re-contributions. Finally, both RRSPs and TFSAs offer tax-free growth of a variety of investment solutions within the plan.
The general school of thought has been to maximize your RRSP contributions annually, mainly because contribution limits made to TFSA’s seem insignificant. Now a couple could contribute in excess of $50,000 to TFSA’s garnering more attention and this resulting debate.
For the majority of investors, the crux of the decision comes down to taxation and the variation between your current marginal tax rate versus the tax rate at some future point in time when you start to draw funds from your savings plan. The simple math concludes that if your marginal tax rate is expected to increase from now to retirement, then TFSA contributions make more sense since you won’t face tax on withdrawals later. On the flip side, if you expect your marginal tax rate to be drop by retirement then an RRSP generally makes more sense.
But how does this really play out for your specific situation? If you taxable income is currently low, as with many business owners, or you are on parental leave or on sabbatical, and you expect to earn a higher income in the future, you are a good candidate for a TFSA contribution. Furthermore, the potential RRSP deduction will not have as much impact on taxation today as it may in the future, so deferring your RRSP contributions may have a greater impact on your overall net worth.
If you receive benefits such as Old Age Security, the Guaranteed Income Supplement, child tax benefits, or GST credits, withdrawals from a TFSA won’t affect your income and therefore will preserve your benefits. Withdrawals from an RRSP will impact these benefits therefore a TFSA may be a better option.
Some other factors to consider beyond taxation when contemplating an RRSP or TFSA are one’s age and stage of life. TFSAs may be more appealing to seniors since there is no age limit for contributions. The type of investments you are considering for the plan also come into play. If you are expecting “supernormal” rates of return on an investment, a TFSA will be appealing because you won’t face taxation on the sale and de-registration of those funds. The timeline of the investment is also a factor. TFSAs are appealing if you do not require the funds to cover income needs as they do not have required withdrawal rates at a certain age, unlike RRSP’s when you must convert the plan to a RRIF when you reach age 71 and begin making annual minimum withdrawals the following year. Finally, if you are saving for short-term goal, TFSAs can offer greater flexibility.
RRSPs offer a psychological advantage in that many people are hesitant to make withdrawals due to the tax applied, which could result in greater savings. Generally, individuals are able to contribute more to an RRSP than a TFSA. Confused? The reality is that both options likely play a role in the make-up of your net worth. To truly understand which option is best for you and to what proportion you should utilize it, a comprehensive wealth plan is a necessity. Contact our office to get your planning process started today.