Successful financial planning involves making wise investment decisions according to your financial situation and goals. As you begin to think about investments for 2021, it is important to be aware of how TFSAs and RRSPs can benefit you. Both these investment instruments can help you save on tax, but they work in different ways.
In this article, we understand both these tax-sheltered accounts and help you know when to invest in one or the other – and when you can invest in both simultaneously.
The Registered Retirement Savings Plan or RRSP is a retirement account that was introduced in 1957 by the government of Canada to help its citizens save for retirement. All the RRSP contributions are tax-deductible, and any returns generated in your account are tax-free until you make withdrawals at a later point.
This is why RRSPs are referred to as tax-deferring vehicles. The contributions towards RRSPs are limited to either 18% of your past year’s income or the deduction limit set by the government ($27,830 for 2021) – whichever is less. Any unused contribution room can be carried forward to the next year.
For example, if you make $70,000 annually, you can contribute $12,600 (18% of $70,000) into your RRSP. When your tax day comes, you will have to pay tax on the remaining $57,400. Meanwhile, that $12,600 will continue to grow in your account and generate returns. You will have to pay a tax on $12,600 (and any gains) later when you withdraw it during your retirement.
The Canadian government has set an upper limit of 71 years till which you can contribute to RRSP. Once you turn 71, you will have to start paying taxes on the accumulated sum and convert it to Registered Retirement Income Fund (RRIF).
Introduced in 2009 to encourage people to save money, TFSA stands for Tax-Free Savings Account. Although, don’t be misled by its name as TFSA is not your regular savings bank account. It functions as an investment basket in which you can add a wide array of financial products to invest in, just like the RRSP.
These include everything from stocks and bonds to ETFs and guaranteed investment certificates. Similar to RRSPs, TFSAs also come with their contribution limits. For 2021, the annual limit stands at $6,000. You can open a TFSA account as soon as you turn 18.
For example, if you were 18 or older in 2009, by 2021, you would have a total contribution room of $75,500. But here’s a big difference, though. While you don’t get a tax deduction benefit on your TFSA contributions you also don’t pay any tax on withdrawals. This is because your contributions are already made from post-tax income.
To go back to our earlier example, if you make $70,000 annually and deposit $6,000 into a TFSA, you will still have to pay tax on $70,000. But when you make withdrawals, you don’t have to pay tax on any gains you have generated .
RRSP v/s TFSA – Which One to Invest In?
In an ideal world, you would be able to make contributions in both TFSA and RRSP and meet the maximum contribution limits. But since that is not feasible for everyone, here’s how you can make the decision:
RRSP is beneficial in the following cases:
- If you make more than $50,000 annually, you might want to invest in an RRSP. The more you earn, the higher the tax bracket you fall in. By contributing to the RRSP, you can enjoy the benefit of deductions and pay tax on the remaining income, which will be comparatively lesser. Plus, when you withdraw your money during retirement, you might be in a lower tax bracket, so you will end up paying less tax.
- RRSP works well for long-term saving goals such as retirement. If you have a sizable chunk of money, you can contribute up to the maximum limit of the RRSP, for which you can later enjoy a reduced tax rate. The extra money can be put in TFSA to set yourself for smart financial planning.
- If your employer is matching your contribution to RRSP as part of a group RRSP plan, grab this tax-shelter with both hands. After all, it’s free money. Even a 2% match on $70,000 gives you an extra $1,400 in your RRSP account.
- Looking to save for education or buy your first home? The Home Buyers Plan (HBP) allows you to withdraw upto $35,000 from your RRSP contribution towards the purchase. The withdrawal must be repaid in 15 years and is tax-free. Similarly, the Lifelong Learning Plan (LLP) allows you to withdraw up to $20,000 over two years for full-time education or training for you or your spouse. You can repay the amount within 10 years.
TFSA is beneficial in the following cases:
- If you earn less than $50,000 annually, investing in TFSA is a smart choice because even after claiming the basic tax credits, you might not be paying too much tax.
- Are you planning to save for a holiday? A TFSA is the better option for short-term goals as it has no tax consequences when you withdraw the money from your account. Nor does it have any withdrawal rules, and it offers a lot of flexibility.
- If you don’t want a timeline attached to your account, TFSA is ideal. As we learnt earlier, when you turn 71, your RRSP account converts into an RRIF account. This makes you obligated to withdraw a minimum amount each year starting from when you turn 72. For a TFSA account, you can continue to contribute for as long as you want, and you can withdraw anytime you want.
The Bullish takeaway
RRSPs and TFSAs each work in distinct ways and have complementary roles when it comes to investments and savings. Depending on your financial situation and goals, you can choose one over the other or use both investment vehicles simultaneously. The important thing is to make regular contributions to an RRSP or TFSA and start saving now.