With the end of January nearing, Canadians are focused on contributing to their RRSPs and getting their tax refunds. In an ideal world we would make maximum contributions to both our TFSA and our RRSP accounts. However, most Canadians simply don’t have enough income to be able to contribute significantly to either plan – yet max out their annual TFSA contribution.
Here at home many Canadians still prefer to contribute to their RRSPs instead of their TFSAs. Yet for many Canadians the TFSA may be a better choice.
The TFSA
The Tax Free Savings Account (TFSA) was introduced by the Federal Government back in 2009, and most Canadians were slow to get on board. But soon enough investors realized this was a great way to shelter their investment income. Here are the basics:
- The TFSA is not an investment. It is a registered plan for sheltering taxable income.
- A TFSA is not just for savings, you can hold mutual funds, stocks, or bonds in a TFSA.
- For 2012 your maximum contribution room is $20,000 (4 years x $5000 per year)
- You can carry forward any unused contributions.
- You do NOT get a tax deduction for contributing.
- You do NOT pay taxes when you withdraw money from a TFSA. Bingo!
- You can use your TFSA investments as collateral for a loan or line of credit.
- You cannot write off the interest from a TFSA loan.
- There are NO age restrictions on the plan – you can hold until your 99 🙂
The RRSP
Most Canadians love their RRSPs! (Registered Retirement Savings Plan). The tax deduction they receive from their RRSP contributions usually results in a tax refund. Here are the RRSP basics:
- A RRSP is not an investment. It is a registered plan for sheltering taxable income.
- A RRSP is not just for savings, you can hold mutual funds, stocks, or bonds in a RRSP.
- You can contribute a higher amount to an RRSP than a TFSA (see your tax assessment).
- You can carry forward any unused contributions.
- You get a tax deduction for contributing. Bingo!
- You pay taxes when you withdraw money from an RRSP.
- You cannot use your RRSP investments as collateral.
- You cannot write off the interest from an RRSP loan.
- You cannot hold your RRSP after age 71. It must be converted into a RRIF, an Annuity, or worst-case scenario withdrawn and declared as taxable income.
It’s All a Matter of Taxes
In a previous post, Max Out Your TFSA, and Forget the RRSP, I discussed the merits of the TFSA over the RRSP. I wrote this post over a year ago, and I still think the same advice holds true for most Canadians.
“Your RRSP contributions compound, growing tax-free, and after several years you will likely double or triple the value of what you originally invested. And if you are younger, that compounded amount could be 4 to 5 times what you originally invested. “
“The tax man will eventually come back for his money he gave you as a refund – in the form of taxes. Money taken out of your RRSP is FULLY taxable, so the more you make the more taxes you pay. Even if you are in a lower tax bracket when you retire, you will still pay tax on all the money you withdraw.”
The main advantage of the TFSA over the RRSP is you can withdraw money from a TFSA tax free. This makes the TFSA an ideal investment plan to save for retirement. You can save tax-free, withdraw tax-free, and reduce the amount of taxes you pay at retirement. Rob Carrick recently did an interview on the benefits of the TFSA for those starting out in the workforce – RRSP and TFSA advice or 20-something investors.
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Those who are higher income earners (over 60K per year) will certainly get a net benefit from contributing to their RRSPs, because the contributions they make to an RRSP will lower their overall taxes paid, and can even place them in a lower tax bracket. RRSPs are a win for these investors!
If you are a high income earner, and you have money to contribute to both your RRSP and TFSA, then consider optimizing your RRSP contributions first. This means you simply contribute the minimum needed to your RRSP to reduce paying any extra income tax. You then take the investing capital you have and max out your TFSA. One of my favorite bloggers, My Own Advisor, covers this strategy in more detail in a previous post – I’ll maximize my TFSA first.
But for the average Canadian, an RRSP contribution does little but shelter income that will be taxed later. Although you will get a tax-refund, which is nice, you will still pay the refund back as taxes when you retire. For the average Canadian the TFSA just makes more sense in the long term!
Disclaimer
Please keep in mind I am not an accountant or professional advisor, and everyone likely has an individual circumstance that is very different from mine or someone else’s. You may find after reviewing your taxes and investment situation that an RRSP, TFSA, or a combination of both is best for you. Please see an accountant or financial planner, before making any important decisions.
The easy solution is to max them both out right? 😉 Basically, from what I can see, it basically boils down to if you believe your marginal tax rate will be similar in retirement as it is now, a TFSA makes more sense. For the high earners (like you said) that will probably have lower income numbers, the RRSP is still the ticket.
Hey MUM thanx for posting! Personally I’m a real fan of the TFSA simply because your investments are tax sheltered, and you pay no tax to withdraw (that includes all those years of compounding income).
At 5K per year the TFSA is a drop in the bucket for some, and others would never even be able to find that kind of capital. I doubt most people could even start to begin thinking about maxing out their RRSP. I say go for the TFSA first, and only RRSP if you need to! IMO 🙂
Cheers
I wholeheartedly agree! I believe everyone should have a TFSA. If you don’t think you have enough money to invest yet, or would rather save your money for an emergency fund, if the money is earning any interest, it should be sheltered in a TFSA. Not the best use of a TFSA, but it can be a start for those who are nervous about investing.
Hey Vicky thanx for posting! Yes I think the TFSA is a win win for everyone, regardless of income or amount invested 🙂
With interest rates at all time lows, not sure an emergency fund is the best use for it, but your right at least its a start!
Cheers
Readers: Be sure to visit Vicky’s site, she has some great posts!
I am a big fan of the TFSA as well and I do both for the record but I need to catch up on my wife’s TFSA.
Most people don’t make use of their RRSP to really maximize the benefits anyways when they use the refund to pay something rather than re-investing it as you mentioned.
The best scenario is probably to put enough RRSP to have the refund fund the TFSA. How’s that? Off to run some numbers now …
Hey PIE that’s the bottom line isn’t it 😉 People get their tax refund and how many actually use it to put into their RRSP or TFSA? I’m guessing most people put it on the credit card (which isn’t such a bad thing).
But yes if you can contribute to both the TFSA and RRSP, or be fortunate enough to max out your TFSA with a combination of cash on hand and/or your refund – then that’s a good thing 🙂
Have fun with your numbers! 🙂
Depends on where you want to go in the present. Unless you can max both out or very close to it, I think focusing on the TFSA is more feasable. You invest quite a bit, so any returns you make would be tax free, and of course you make returns. I follow your stock picks, and not too shabby! 🙂
As for the numbers, I’m going to have a lot of fun…can’t wait for a visit w/my accoutnant (rolls eyes), when you have over $30K of taxable income between two businesses, and that’s on top of the annual salary, a lot of decisions need to be made fast!
Eddie Thanx for posting. I’m obviously pro TFSA for everyone 🙂 But definitely you will be in the fortunate position of being able to max out the TFSA and contribute to the RRSP. That’s a great position to be in, and you are doing the right thing by working out the numbers with your accountant to see what’s best for you.
So you did well with the stock picks eh? Drop me a message and let me know 🙂
Cheers!
Thanks for the informative post.
My only minor quibble is that US dividends/interests is still subject to a withholding tax if placed in a TFSA. But you can avoid it if placed in an RRSP.
aldur1 You are correct, you can only put U.S. Stocks into an RRSP to shelter the dividend income. This is because of the tax treaty between Canada and the US, and becuase the TFSA is relatively new. But in time I think this will change 😉
Thanks for the mention Ninja!
As you know, I’m a big fan of the TFSA, like Passive, but as your post suggests I prefer to optimize my RRSP vs. maximize it.
I’d rather top up my TFSA any day.
Tax-free (TFSA) vs. tax-deferred (RRSP). You can hold dividend-paying stocks in both. No brainer for me which one makes more sense long-term.
I’m not saying the RRSP doesn’t have tons of value, it does…simply why defer so much tax if you have a choice?
Nice stuff as always 🙂
Will include in my Weekend Reading roundup!
Mark
@My Own Advisor
I think it’s also important to have an understanding of the tax bracket you would be in near retirement. That’s why it’s important for people to have a plan.
I find that TFSA is a given but between RRSP and non-RRSP, the RRSP has a major benefit for the tax deferred growth. The $5K limit on the TFSA is not enough for me, and that’s why I can do both. (Ok, I know I need to fill up my wife’s TFSA … but that’s partly due to not having the right discount broker and I am working on that)
This is my order TFSA, RRSP and non-RRSP except that I am not sure what the right balance is between RRSP and non-RRSP? I can’t max out my contribution every year and I have a LOT of contribution room anyways. Also, I find holding US stocks is better in the RRSP from a tax perspective.
Did I just make it more complicated?
Good conversation gents! I am always looking at how to maximize my return 🙂
PIE Good for you being in the situation of being able to max out the TFSA and contribute to the RRSP 🙂 Now all you have to do is juggle the numbers and get the maximum refund you can!
btw I just saw your post this morning you did on the RRSP,it looks awesome and I’m going to check it out shortly!
PIE I will disagree with you on one point, looking at the consideration of your taxable income in retirement. I’m going to be a devil’s advocate here and say the issue is irrelevant – any extra tax you pay at retirement is not a positive thing 😉 If I can Max out my TFSA, I will do that first without question regardless of my income.
If you are not going to make efficient use of your tax refund, then TFSA is definitely the way to go first. Otherwise, I still (even if you disagree) think that someone needs a plan and look at their goals upon retirement. It also depends on the investment you plan on doing. Since both have tax free growth, it’s probably not a big deal but if US dividend investments come in, it can be a factor. It’s also important to consider the spousal setup you will have if you are married.
I do maximize my TFSA and I do my RRSP. My personal dilemma is in doing more RRSP or more non-registered …
For someone with less to invest, doing RRSP and making use of the tax refund definitely puts more money at work. No one can question that. Especially if the return is in your TFSA. Is more money at work going to be less if you have to pay taxes later on? Extrapolating for the future can get nebulous at times. What’s the growth rate, what’s the saving rate and so on becomes so unpredictable. Time to run some numbers 🙂
The reality is that RRSP hasn’t been a success as a long term retirement plan. I am not sure if TFSA is considered a success globally either. Those plans are meant to help grow a nest egg but it would appear that the same people make use of the strategies so the same people benefits from them …
MOA Your post on optimizing the RRSP was very in-depth and a good resource. Most people like the immediate satisfaction of a tax refund. But like yourself, I like the idea of NOT deferring my taxes 🙂
That’s the thing I don’t get. RRSP, taxes deferred. You are prolonging the evitable.
Who knows what tax bracket you might be in later on in life. Who knows what the tax rules will be later on with any given government.
Right now, we know the TFSA is tax-free with no strings attached. It makes absolutely the most sense to maximize this account first, and worry about your RRSP later.
For many Canadians, unless you’re a high-income earner, RRSPs shouldn’t be used IMO.
@PIE,
I guess that’s my struggle, it’s pretty difficult to forecast where you’ll be in 20, 30 or 40 years when you need to convert the RRSP to a RRIF.
I’d rather focus on what I know now, my TFSA.
Now, you bring up an interesting point. The RRSP vs. non-RRSP. I like the idea of having many dividend-paying stocks outside registered accounts, with the dividend tax credit provided on some cash flow for investing or saving purposes. Lately, I’ve been focusing on the following model:
-Maximize TFSA (done for 2012)
-Optimize RRSP (usually $2,000-$3,000 per year)
-Investing in non-registered account and increase cash flow
Great discussion gents. We need to do this over some pints 🙂
Mark
Mark, I wholeheartedly agree! I especially like these points:
“That’s the thing I don’t get. RRSP, taxes deferred. You are prolonging the evitable… Right now, we know the TFSA is tax-free with no strings attached. It makes absolutely the most sense to maximize this account first, and worry about your RRSP later.”
Thanks for this post. It looks like I was pretty ignorant about my TFSA. I had no idea that it could be used for more than just savings. Personally I had been only contributing to my RRSPs because I plan to take most of it out for a mortgage downpayment. Since I’m a 1st time home buyer, I’d get the tax credit. Of course I’d have to contribute that amount of RRSPs again within their time limit.
Modest Money Thanx for dropping by man! Yes RRSPs and TFSAs are just plans not investments, you can have self directed, mutual funds, savings, whatever you want in them 🙂
Yes the RRSP Home Buyer Plan is a good deal!
Cheers
Hi Ninja,
I am interested in investing in 2 stocks. The first is a high yielding US stock with some growth potential, the other is a Canadian stock which is relatively inexpensive, no yield and a little speculative, significantly more growth potential. Which of these would you put in a TFSA vs an RRSP and why ? I am looking at putting 1 in each for sure.
SAD,
There is no question here. Any U.S. stock should go into an RRSP, and the Canadian Stock should preferably go into the TFSA first.
U.S. income (dividends or otherwise) will be taxable in the TFSA, at your full marginal tax rate. In the RRSP, income from the U.S. stock would be non-taxable (tax deferred).
Cheers
Dividends in a tfsa are taxed at 15%. They aren’t in an rrsp. However, when you retire, I believe most people will be paying more than 15% in taxes to use your rrsp money. If you pay the 15% upfront in your tfsa account, couldn’t you use the other 85% of your dividend to contribute to your rrsp and reduce your current income tax? Of course that contribution would be taxed again when you retire but I’m wondering if the 85 % of your dividend is worth using to reduce your current income tax by transfering it into your rrsp.
For math, I make about $60 000 and I’m 35. I try and put $5000-$6000 into my rrsp each year and put my income tax return into my tfsa and use the $5000-$6000 from my tfsa to contribute into rrsp so I don’t have to save it every year. My return is usually around $5000 since I’m self employed.