In Canada we have two great savings vehicles sanctioned by the government. We have the venerable RRSP (Registered Retirement Savings Plan) introduced in 1957 and the more recent TFSA (Tax Free Savings Account) introduced in 2009. What are the pros and cons of each and when should you use one or the other or both?
RRSP - Facts
This year (2018 Tax Year) you can contribute an amount equal to 18% of your Earned Income from the prior year (2017) up to a maximum of $26,230. This amount will be reduced if you are contributing to a company pension plan where you work.
If you have not contributed in the past, or not contributed the maximum, the unused contribution room from past years is accumulated and can be used in the current year.
The amount you are able to contribute to your RRSP in 2018 is shown on your Prior year (2017) Notice of Assessment in the RRSP/PRPP Deduction Limit Statement.
This is the also the amount you can deduct from your Taxable Income in 2018 and reduce your Income Tax owing.
When it comes time to withdraw from your RRSP (in retirement or at any other time) all amounts taken out are taxable. Income Tax will be paid at your marginal rate.
TFSA – Facts
This year (2018) you can have made cumulative contributions totalling no more than $57,500. The amount you may contribute is cumulative with yearly maximums as shown below
2009 – 2012 $ 5,000/yr $20,000
2013 – 2014 $ 5,500/yr $11,000
2015 $10,000/yr $10,000
2016 – 2018 $ 5,500 $16,500
Total Cumulative Contributions allowed: $57,500
The amounts contributed ARE NOT tax deductible like RRSP contributions. They are made in after tax dollars.
Money deposited into your TFSA may be invested in pretty much anything that would qualify for an RRSP investment. (stocks, bonds, mutual funds etc.)
When it comes time to withdraw from your TFSA, ALL amounts withdrawn are TAX FREE. Yes even the income earned on the investments in the TFSA
Marginal Tax Rate – What is That?
In Canada we pay income tax on a graduated scale. In Ontario it looks like this:
Taxable Income Tax Owing
0 - $15,087 $0 Plus 15.00% on excess
$15,088 - $19,819 $492 Plus 25.10% on excess
$19,820 - $42,960 $1,680 Plus 20.50% on excess
$42,961 - $46.605 $6,319 Plus 24.15% on excess
$46,606 - $75,653 $7,200 Plus 29.65% on excess
$75,654 - $85,923 $15,812 Plus 31.48% on excess
$85,924 - $89,133 $20,133 Plus 33.89% on excess
The Marginal Tax rate is the rate paid on the last dollar of taxable income. From above we see that if your taxable income is $87,000 the marginal tax rate is 31.48%. For every dollar earned above the $87,000 you pay 31.5 cents in tax. (until you reach the next level, then you pay more!)
Which Should You Invest In, RRSP or TFSA?
The answer is “it depends”. Typical accountants answer! There are a few factors to consider.
First, what is your marginal income tax rate going to be when you plan to take money out of your RRSP or TFSA? Why does this matter?
When your taxable income is low, and you’re looking at paying little or no tax, it does not make sense to contribute to an RRSP. Your marginal tax rate is probably in the neighbourhood of 25%, meaning you’d save $250 in income tax for each $1,000 you put in an RRSP. The issue is that when you are retired you’ll probably have a much higher income than you do now and hence a higher marginal tax rate. It would be reasonable to anticipate a marginal tax rate of 35% (at least) and so for each $1,000 you withdraw you would pay $350 in tax.
It doesn’t make sense to defer income until a time when you will pay more tax on it! This is the time to top up your TFSA as much as allowed and to keep any other savings in a non-registered investment account. You can always transfer it later to either a TFSA or RRSP.
As your taxable income increases it makes more and more sense to contribute the maximum to your RRSP. As your marginal tax rate increases the savings in income tax become substantial. You could now be looking at a marginal income tax rate of 45% (or more) which means that you save $450 in income tax for each $1,000 that you contribute. But when withdrawing in retirement at the anticipated 35% marginal tax rate you’ll only pay $350 income tax for each $1,000 you withdraw. This being the whole point of the RRSP, allowing you to defer paying tax on a portion of your income until a time when your marginal tax rate is lower!
So generally speaking you want to contribute to your TFSA and non registered account until your marginal tax rate matches or exceeds your anticipated marginal tax rate at time of withdrawal.
At this point you want to start contributing to your RRSP. You would be very wise to take any refund generated by your RRSP contribution and use it to max out your allowable contribution to your TFSA.
If, throughout your working life, you always maximize your RRSP and TFSA contributions, you will have no financial concerns about retiring.
Other Things to Think About
RRSP’s must be converted to RRIF’s (Registered Retirement Income Funds) or annuities in the year you turn 71. RRIF’s must pay out a minimum percent of the total value per year, so if you have a large amount saved up in your RRSP it will start becoming taxable income in you’re 72nd year. This can increase your income, and marginal tax rate depending on the size of your RRSP/RRIF investments.
On the other hand TFSA’s do not need to be converted. Of course, any non-registered investments do not need to be converted either.
A reasonable balance of your retirement investments between registered and non-registered accounts is wise and the best solution for the investor is one worked out in concert with their investment manager(s) and tax advisor.
Still not sure whether you should use a TFSA, RRSP or both? Reach out to your investment manager or advisor or contact our financial consultant at firstname.lastname@example.org.
Disclaimer: Numbers, tax rates, suggestions and other details here are not exhaustive and should not be construed as investment advice. The information provided is for discussion purposes only and is meant to provoke interest in the reader and motivation to pursue their personal investment/retirement goals in concert with their investment advisor(s)/manager(s).