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Should You Contribute To An RRSP Or A TFSA?

12/14/2015 04:10 EST | Updated 12/15/2016 05:12 EST
Anthony Rosenberg via Getty Images

One of the most common questions I receive every week is, "What is the difference between an RRSP and a TFSA and which one should I get started with?"

First, what does each acronym mean? An RRSP is a Registered Retirement Saving Plan, and a TFSA is a Tax-Free Savings Account. Both are provided by the Canadian government as incentives for Canadians to save, primarily for retirement.

The basic differences are as follows:

2015-12-13-1450020077-5245441-RRSPTFSAtable.png

To illustrate this for you, let me introduce you to Betsy:

Betsy is a 24-year-old graphic designer and is employed by The Awesome Lipstick Company. She currently earns $38,000 per year but has been taking advanced Photoshop and web design courses, with the goal of becoming the firm's director of design.

2014 was the first year Betsy earned employment income and so her 2015 RRSP contribution limit is $6,840*. (38,000 x .18 = 6,840)

Betsy has never contributed to a TFSA and so her allowable contribution limit is $41,000**.

Since she started working in February 2014, Betsy has been saving $500/month and now has $10,000 that she is ready to invest.

Which account should she choose?

Considerations:

  • Both the RRSP and the TFSA will allow her funds to grow tax-free.
  • Contributing $6,840 (the maximum allowable) to her RRSP will reduce her income by the same amount. Assuming a marginal tax rate of 25 per cent, she will receive 2015 refund of $1,710.
  • Contributing the entire $10,000 to a TFSA will not provide Betsy with any tax relief for 2015.

So, it's obvious she should contribute to the RRSP, right?

Not so fast.

Betsy needs to consider that she is young and how her future earnings could change over the next decade. For example, if, in the next five years, Betsy's income grows to $120,000 her marginal tax rate for 2020 could be upwards of 45 per cent.

Assuming at that point, she has $30,000 of unused contribution room in her RRSP, she could split into two contributions 2020 and 2021. Each contribution would be $15,000 and, all things being equal her tax refund for each year would be would be $6,750 for a total of $13,500. (15,000 x .45 = 6,750 x 2 = 13,500)

This example is getting a bit more complicated than I wanted it be, but my point is that you only get one chance at an RRSP contribution (it is not a finite amount). As such, it can be best to wait to contribute to an RRSP until you are in a high marginal tax rate.

(in Betsy's case, 45 per cent over 26 per cent)

Pre-2009, this decision had to be weighed against your early contributions not growing tax- free--a compound interest benefit not to ignored. But now, in 2015 your initial funds can grow tax-free in a TFSA, and so the issue is somewhat mitigated.

My advice to Betsy would be to contribute the entire $10,000 she has for investment in 2015 to a TFSA. As her income grows, along with her marginal tax rate, she can start adding to an RRSP.

Important Note:

The tax relief you receive from contributing to an RRSP is only deferred. The idea being that you contribute at a high marginal rate (i.e. 45 per cent), and then you withdraw (at age 71) ), paying a lower rate (i.e. 26 per cent). You base this strategy on the assumption you have a lower income in retirement. You know, because you are no longer working.

But there is no way of knowing at age 24 what your income will be in retirement. It is entirely possible that you will be massively successful, earning $100,000+ year, and thus still paying 45 per cent taxes on your (forced!) RRSP withdrawals.

In comparison, the money withdrawn from a TFSA is not taxed at the time of withdrawal. You paid tax on the income used to contribute to the TFSA, you did not receive any tax relief on contribution, and so therefore it is not taxed again.

Also, you can continue to contribute to a TFSA up until your death. (Versus the RRSP that forces you to not only stop participating but also to start withdrawing at age 71).

All this to say that in a perfect world, you will max out both your RRSP and TFSA contributions early and often (and at a high marginal tax rate for the RRSP). But since the world is rarely perfect, and if you are not in a high tax rate, my vote is for the TFSA.

Footnotes:

How RRSP and TFSA contributions are calculated:

*RRSP: This number is mandated by the Federal government. The simple calculation is 18 per cent of your previous year's income, up to a maximum amount of $24,930. As Betsy earned $38,000 in 2014, her maximum allowable contribution is $6,840 (38,000 x 0.18).

A couple of notes:

Unused RRSP contributions are carried forward indefinitely (yes, this rocks!).

I say simple calculation because, in reality, it is not that simple. Pension adjustments, carry-forward amounts, varying maximum amounts for previous years, etc. can all affect your maximum allowable amount for any given year.

Your annual Notice of Assessment (sent you after filing your income taxes each year) will have your next year's allowable contribution. You can also call the CRA, and after answering 3,251 security questions (LOL), they will provide it to you.

**TFSA: This amount is also mandated by the Federal government. The TFSA came into effect January 1, 2009. The allowable amounts for every Canadian over 18 are as follows:

2015-12-13-1450020963-7068075-TFSAAnnualLimit.png

If not used, TFSA amounts also carry forward indefinitely. Meaning, if Betsy (or you) do not contribute in 2015, her (and yours) allowable contribution will be $46,500 ($41,000 + an additional $5,500 for 2016).

Ok, that's it for this post. If you have any questions, don't be shy to visit Ask Nanci.

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