In my consulting practice I’m often asked by those not-yet-retired, which savings vehicle is better, a tax free savings account (TFSA) or an Registered Retirement Savings Plan (RRSP). As is often the case with financial questions, the answer is very much dependent on the individual’s specific circumstances.
Although most of us are quite familiar with RRSPs, some confusion still exists around the TFSA program which was introduced by the Federal Government in 2009. Both the RRSP and the TFSA are tremendous vehicles for individual and family wealth-creation — if used wisely.
The RRSP offers the instant advantage of a tax refund. It is calculated on the dollar amount contributed, using the same percentage which applies to the contributor’s marginal tax rate. If for example, an individual is in a 30 per cent marginal tax rate, a $5,000 contribution to an RRSP will result in a $1,500 tax reduction. Funds invested through an RRSP can grow and accumulate totally tax-free, until actually withdrawn. The downside is that once withdrawn, the funds attract tax in the same manner as earned income.
RRSP contribution eligibility continues to accumulate as long as an individual has employment income. It is not lost, even should funds not be contributed for many years. An RRSP is of questionable value for those in lower tax brackets, as for instance, young people at the beginning of their career. Until their marginal tax rate is at least 30 per cent, they would be better served by utilizing the TFSA savings vehicle.
While the TFSA contribution does not trigger a tax reduction, neither does it attract tax on investment growth within it, whether from interest, dividends or capital gains. Since 2009, all Canadians over age 18 have accumulated $5,000 of annual eligibility in a TFSA, immediately upon opening a TFSA at their financial institution. By 2011 therefore, each of us has accumulated $15,000 of eligible contribution room. On January 1, 2012 another $5,000 will be added to our eligibility. As with an RRSP, the annual increase in contribution eligibility is never lost, even if not fully utilized.
The simple rule-of-thumb is that individuals with a high marginal tax rate would normally opt to make a contribution to an RRSP rather than a TFSA. In an ideal world, the high-income earner would utilize both programs to the limits permitted. Since few are fortunate enough to be able to do that, an annual choice must often be made.
As one’s career progresses and with it, incomes and marginal tax rates increase, the focus shifts to an RRSP as the priority savings vehicle, with its substantial tax-reducing benefit.
The key objective of the above strategy is to ensure that we pay the least-possible tax over our lifetime. No one retiring with a major RRSP investment account wants to be paying a higher tax rate on funds withdrawn from their Registered Retirement Income Fund during retirement, than they received as a tax reduction when they made their original contributions. Generally, the optimal solution is to delay taking advantage of RRSPs until the resulting tax refund is at a high marginal tax rate.
For retirees who can no longer utilize an RRSP, the TFSA is an excellent vehicle for investing extra cash. It becomes a great way of building a significant nest-egg which can grow totally tax-free, and can be tapped without penalty at any time. Another excellent feature of the TFSA is that funds that are withdrawn can be replaced partially or in full, in any subsequent year.
Still confused about which choice is best in your particular circumstance? Seek the advice of an accountant who can help you make the right decision.
One more item to note. The whole RRSP versus TFSA decision may be premature if an individual is carrying debt, especially high-interest debt such as on credit cards. There is little logic to having debt at a higher rate of interest than can reasonably be expected to be earned in any investment vehicle, whether an RRSP or a TFSA.
A retired corporate executive, enjoying post-retirement as a financial consultant, Peter Dolezal is the author of three books. His most recent, The Smart Canadian Wealth-Builder, is now available at Tanner’s Books, and in other bookstores.
The information contained in this column is for information purposes only. The investment and services mentioned in this column may not be suitable for everyone.
Contact an independent financial advisor before making any investment decisions.