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How To Get the Most Out of Your RRSP Contribution

02/28/2014 06:17 EST | Updated 04/30/2014 05:59 EDT

RRSP contribution, Tax Free Savings Account or pay down my mortgage? When it comes to that extra bit of cash you have, you really have so many choices.

Are you often feeling confused over what decision to make? Have you been inundated with information and options, almost to the point of indecision? It is no longer enough to remain loyal to your employer for decades in return for a comfortable retirement. We should become involved in our retirement planning and make some tough decisions, especially considering that according to the Sun Life Canadian Unretirement Index 33 per cent of Canadians feel there is a serious risk that they will outlive their retirement savings.

With the 2013 RRSP contribution deadline quickly approaching (March 3), it makes sense that RRSPs are at the forefront of our financial consciousness. Are you making the most of your RRSP contributions? The RRSP gives you an immediate tax break and the contribution is deductible from your yearly income. You pay tax on the money when you withdraw it -- albeit, ideally, in a lower tax bracket in retirement.

A TFSA doesn't give you the upfront tax break and all the growth is tax-free when you withdraw it. How can you compare the pros and cons of two such completely diverse options? Short answer: it is difficult unless you know exactly how your finances will pan out down the road, which tax bracket you will be in and what these tax rates will be. Why not, instead, cast a wide net and obtain everything you can from any tax breaks available to you.

So, how do I respond to the question I hear so often from my clients: Should I contribute to an RRSP or a TFSA? I say: Compound your tax refund!

We know that an RRSP contribution will reduce your tax bill, either resulting in a refund or lessening the amount of tax you pay. What you do with the savings is the key. Do you reward yourself with a beach vacation just because you were so awesome last year? Consider downsizing your reward a bit (even though you really were awesome) and treat yourself to a special dinner or night out. Reinvest the majority of your tax savings to either start or top up your TFSA.

You have now turned that RRSP contribution into an RRSP contribution AND a TFSA contribution. In addition, you also provided yourself with flexibility and options for the future. The TFSA could be used for:

• Retirement income (add a tax-free income source to your RRSPs and RRIFs).

• Future RRSP contributions. Convert the tax-free growth into a tax-deduction.

• A future lump sum mortgage payment. Grow your TFSA over time and then apply the principal and tax-free growth to your mortgage. Consult your advisor to see if this strategy makes sense for you (versus simply paying down your mortgage each year).

• An Emergency Fund. Even if you have long-term goals for the TFSA, sometimes things change and we need to backtrack a bit. If this happens, don't fret. Just meet with an advisor to develop a plan to get back on track.

If you contribute $5,000 a year to an RRSP and put the tax savings in your TFSA every year for 20 years, you will have over $250,000!** But, if you spend your annual refund on the fad of the moment, you will have taken a 25 per cent chunk out of your retirement nest egg.

In short, there are so many ways to take advantage of the breaks given to us by CRA. We have to be strong and focused. Resist the temptation to take your refund to the nearest mall in an effort to boost the economy and someone else's bottom line. Now, you are armed with a strategy!

With only about one third of Canadians making an RRSP contribution according to the Sun Life Annual Check-up Survey, make this year the year that you start to reap the benefits of your RRSP. Top up your RRSP before March 3 and make an appointment with your advisor to plan how best to invest your tax refund (or tax savings). Your tan may suffer but your net worth will thank you.

**Based on a 32 per cent marginal tax rate and a 6 per cent compounded, annual rate of return.

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