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A taxing decision: RRSP or TFSA?

Making your best choice for tax-sheltered savings.

When the federal government introduced the Tax Free Savings Account (TFSA), Canadians suddenly had another tax-saving tool. But they also had something else – a dilemma.

How you shelter income isn't as clear-cut as it once was. To reduce taxes and build savings, the TFSA offers its own advantages over the traditional RRSP.

So which is best? The truth is RRSPs and TFSAs can work together in helping you achieve your goals. Ideally, by contributing to both plans you'll be able to maximize your tax savings. But emphasizing one option over the other can make sense, depending on your current circumstances, future expectations, and overall financial plan.

RRSPs and TFSAs: how they're different

RRSPs and TFSAs have a common ability to shield your income from tax. Practically every investment that's RRSP-eligible can be held in a TFSA, from mutual funds* and stocks* to term deposits and savings accounts. But it's the differences between them that have important implications when you're trying to reduce your tax burden.

Treatment of contributions and withdrawals. One of the key differences between RRSPs and TFSAs is how they treat contributions and withdrawals when it comes to taxes.

TFSA contributions are not tax deductible, while RRSP contributions can be deducted to reduce your taxable income. It appears that RRSPs would have the advantage here, but it's not always the case.

Because TFSA contributions are made from after-tax income, there's no tax to pay when those funds are used at a later date. Putting money into an RRSP will give you a tax deduction today, but also leaves you with a future tax obligation. You'll still enjoy tax-deferred growth while those funds remain invested, but remember that you'll eventually owe tax when they're withdrawn.

The same principle arises with TFSAs and RRSPs in estate matters. A TFSA can be transferred to a surviving spouse tax-free, while generally the transfer of an RRSP simply delays taxes until the surviving spouse's death or when the money is finally taken out.

Maximum contributions.  The Tax-Free Savings Account annual contribution limit for 2019 is $6,000, and the total accumulation limit allowed is now $63,500. Contribution room is cumulative and will be carried forward indefinitely.

How much you can put annually into an RRSP is dependent on how much you make. For 2019, the maximum RRSP contribution is 18% of your 2018 earned income to a maximum of $26,230 (subject to certain adjustments). That means if you're a high, or even a moderate income earner, the greater contribution room available through an RRSP can help you build tax-sheltered saving faster than through a TFSA.

Re-contributing funds. Both RRSPs and TFSAs allow you to carry forward unused contribution room indefinitely. But that's where the similarity ends.

For flexibility, TFSAs have the edge. When you withdraw from a TFSA, that amount is automatically added to your contribution limit for the next year. This allows you to "re-contribute" funds again and again.

For example, you take $2,000 out of your TFSA. Assuming you're not carrying forward any previous contribution room, you'll be able to put in $8,000 next year - that year's $6,000 limit plus the $2,000 in "room" created by your withdrawal.

An RRSP doesn't have the same benefit. When you withdraw funds, your contribution room is gone for good. You can't simply "put back" the funds as you can with a TFSA, unless you're doing so through an approved program like the Home Buyer's Plan or Lifelong Learning Plan

Avoiding TFSA over-contributions

Looking forward to taking advantage of the TFSA's flexibility? It's important to understand how re-contribution works so you don't wind up paying, instead of saving.

When you withdraw funds from your TFSA and you have no unused contribution room remaining, then you must wait until the following year to re-contribute that amount. Making any excess contribution beyond your annual limit triggers a penalty tax of 1% per month on the excess amount until the over-contributed amount is withdrawn.

For the latest information concerning taxes payable on excess TFSA contributions, visit the Canada Revenue Agency website.

Effect on government benefits. Once you retire, having a high income can impact benefits you receive from government, including Old Age Security (OAS).

Withdrawals from an RRSP must be counted as income for tax purposes, so they have the potential to not only bump you into a higher tax bracket, but also leave you open to a "claw back" of benefits. For example, you'll lose 15 cents of OAS for every dollar your income is above $75,910 (for 2018). If your income's high enough, you could lose your benefit altogether.

TFSAs don't create the same problem. Withdrawn funds aren't added to income, so there's no risk to your benefits.

There are some situations, however, where contributing to RRSPs can actually enhance means-tested benefits. For example, if you're eligible for the Canada Child Tax Benefit, an RRSP deduction lowers your taxable income helping you qualify for a larger payment.

Sheltering US dividends. Normally when Canadian investors receive dividends from US corporations, a 15% withholding tax is levied by the Internal Revenue Service on these payments. A Canada-US treaty nullifies this tax if the investments are held in an RRSP. The same isn't true if you hold them in your TFSA; the tax still applies.

Marginal tax rates: the deciding factor?

When you're saving for the long-term, does an RRSP or TFSA give you the best chance at a larger nest egg?

The answer depends greatly on what your tax rate is now and what you expect it to be in the future. Will it be the same, higher or lower?

If your marginal tax rate stays the same, it won't matter. Investing identical amounts in each option, assuming the same rate of return and investment period, will yield the same result.

Here's why: although tax on your earnings leaves you less money to compound in a TFSA, you won't pay any more taxes on your investment's growth.

On the other hand, avoiding taxes upfront lets the full amount of your RRSP contribution grow, but you'll give back a chunk when the funds are withdrawn.

Example 1: Same marginal tax rate now and later

TFSA and RRSP leave same net proceeds under this scenario.

TFSA and RRSP leave same net proceeds under this scenario
 TFSARRSP
Contribution $5,000 $5,000
Taxes (40% tax rate) $2,000 None
Net contribution $3,000 $5,000
     
Annual investment return 5% 5%
Years invested 25 25
Value before withdrawal $10,159 $16,932
Taxes (40%) None $6,773
     
Net proceeds $10,159 $10,159

Where the situation is different, and where one choice can be better than the other, is if the tax rate you're paying when making your contribution is higher or lower than it will be when the funds are taken out. The more rates change, the more advantage there is.

Let's take two examples comparing after-tax proceeds from equal RRSP and TFSA contributions under shifting marginal tax rates.

Example 2: Higher marginal tax rate now, lower later

This is a typical retirement scenario. Your income and tax rate will be lower in the future than they are today. This is the case where the RRSP has the advantage.

TFSA and RRSP leave same net proceeds under this scenario
 TFSARRSP
Contribution $5,000 $5,000
Taxes (40% tax rate) $2,000 None
Net contribution $3,000 $5,000
     
Annual investment return 5% 5%
Years invested 25 25
Value before withdrawal $10,159 $16,932
Taxes (30%) None $5,080
     
Net proceeds $10,159 $11,852

Example 3: Lower marginal tax rate now, higher later

This scenario might occur where an inheritance or other windfall causes investment income to rise in retirement. Here the TFSA yields a higher after-tax benefit.

TFSA and RRSP leave same net proceeds under this scenario
 TFSARRSP
Contribution $5,000 $5,000
Taxes (30% tax rate) $1,500 None
Net contribution $3,000 $5,000
     
Annual investment return 5% 5%
Years invested 25 25
Value before withdrawal $11,852 $16,932
Taxes (40%) None $6,773
     
Net proceeds $11,852 $10,159

There's more to consider

While marginal tax rates have a strong influence over the RRSP/TFSA decision, there's often more to figuring out which is the best option in the bigger picture. Here are some additional key factors to keep in mind.

TFSA and RRSP don't have to be "either/or". Think of the RRSP and TFSA as complimentary rather than competing options for your money. Each has unique advantages and disadvantages. The TFSA's flexibility makes it ideal when saving for short-term goals like a vacation or home renovation. For retirement savings, RRSPs might take priority.

Which option you favour can also change at different points in your life. For example, someone relatively early in their career may be better off sheltering money in a TFSA to start, and then transferring those funds to an RRSP and claiming a larger tax deduction once they're earning a higher income.

Are you maxing out your RRSP? If you're already maximizing your RRSP contributions or have limited contribution room (because of a company pension plan, for example), a TFSA can boost your tax savings.

Can you split income with your spouse? Worried what a healthy retirement income and high tax rate will eventually do to your RRSP savings? There's a tax strategy that can add value to saving through an RRSP.

If you're over 65 and convert your RRSP to a RRIF or annuity, that pension income can be eligible for income splitting. If you have a spouse in a lower tax bracket, splitting your retirement income with them can reduce your combined tax bill and leave more of your RRSP in your hands. You'll be able to enjoy much higher retirement income before there's any danger of a claw back in benefits.

How much access do you need…and can you handle? If you want frequent and easy access to your sheltered funds, the TFSA is the way to go. You won't pay tax on every withdrawal like you will with an RRSP. And, you can re-contribute the funds in future years so they'll be there when you need them.

But if you're having a hard time staying disciplined with your savings, will having easy access to your funds in a TFSA be too tempting? If you choose an RRSP instead, knowing you'll have to pay tax on every withdrawal might be the deterrent that keeps your plan on course.

Remember that the tax benefits of TFSAs and RRSPs won't mean as much if poor planning elsewhere is costing you.

For instance, if you do contribute, make sure you've organized your assets tax efficiently. That means sheltering your fixed income investments and leaving equities, for example, in a non-registered account to take advantage of the Dividend Tax Credit and preferred taxation on capital gains.

The RRSP contribution deadline for the 2018 tax year is March 1, 2019. Your BlueShore financial advisor can review your situation and goals to help you use TFSAs and RRSPs to your best advantage. Contact us to learn more.

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