RRSP or TFSA contributions – which should I choose?
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Registered Retirement Savings Plans (RRSPs) and Tax Free Savings Accounts (TFSAs) are two types of registered savings programs. Canadians are encouraged to contribute to both types of savings vehicles, but how do they really compare?
Both strategies benefit from the ability to shelter otherwise taxable investment growth over a period of time. In the case of a TFSA, contributions are made with after tax dollars, while a contribution to an RRSP will reduce taxable income in the year of the contribution. During your high income working years, the vote seems to favour the RRSP contribution to minimize annual tax payable.
However, any withdrawal from an RRSP is fully taxed at the time of withdrawal. A withdrawal from a TFSA can be made tax free, at any time, and the funds can even be recontributed to the TFSA at a later date. This provides a level of flexibility unmatched by the RRSP.
Timing and tax rates
When comparing the benefits of contributing to either an RRSP or TFSA, it is important to look at your current tax rate when the contribution is made, and projected tax rate at the time of withdrawal. RRSPs were designed for those individuals who expect to be in a high tax bracket during their working years and a lower tax bracket in retirement. The chart below illustrates this scenario and clearly shows the benefit of the early RRSP contribution (20 years prior to retirement).
If you have had great success at growing your investments and retirement funds during your lifetime, in reality you may remain at the higher tax bracket throughout retirement, essentially nullifying the early benefits of the RRSP contributions.
The scenario reverses in the case of a young adult contributing to an RRSP early in their career, when they are at a much lower tax bracket. In this case, there is a clear benefit to contributing to the TFSA early on. See the chart below for that comparison.
Consider when you will need the funds
So when determining where to make your contributions you should consider your needs. The flexibility of the TFSA is valuable if you need the funds for emergency or major purchases during your lifetime or if you are subject to income tested benefits, such as OAS clawback, the age credit and deductible medical expenses. An annual contribution of $5,500 in 2013 along with continued annual contributions during your lifetime will provide a tax efficient savings plan.
But don’t discount the RRSP contribution entirely! You can contribute up to 18% of earned income to a maximum of $22,970 for the 2012 tax year. This contribution will reduce your tax payable this year and ensure your retirement nest egg continues to grow over time. High income earners should certainly take advantage of both savings programs.
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Don’t miss the RRSP contribution deadline! The deadline for contributions for the 2012 tax year is Friday March 1, 2013.
To make your annual TFSA and RRSP contributions, or to receive our complimentary RRSP 2013 Reference Guide, contact your Richardson GMP Advisor.