Which type of account should I use to save for my retirement?
Years ago the answer to this question was straightforward as most investors used the Registered Retirement Savings Plan (RRSP). With the introduction of the Tax Free Savings Account (TFSA) in 2009 many investors are contemplating whether that is the better choice. The actual answer is that it depends on a number of factors.
Before providing an analysis we need to understand how each account works.
The RRSP allows for yearly deposits which in turn reduces one’s taxable income in any given year. Generally, the maximum contribution for the year would be 18% of the individual’s previous year’s income, less any adjustment from pension contributions. Any excess contribution room can be carried forward for use in the future. All income earned within the RRSP grows on a tax-deferred basis, meaning no tax is payable on these incomes each year.
When it’s time to take the money out of an RRSP, presumably at retirement, the total withdrawal will then get added back to an individual’s taxable income. Ideally, one will be in a lower tax bracket from when the contribution was made, but possibly not.
The TFSA allows for yearly deposits with after-tax dollars of up to a pre-defined limit set by the government of Canada. As of 2018 the TFSA maximum limit totals $57,500. Similar to RRSP, any unused contribution room can be carried forward indefinitely to future years. Deposits made to the TFSA do not reduce taxable income for that year; that said all gains occur tax free even at withdrawal.
So, understanding how each account works we can start to consider strategies for saving for retirement.
Individuals generally benefits from RRSP over the long run when the tax rate at contribution exceeds the tax rate on withdrawal. For example, an individual contributes to RRSP when they are in a high tax bracket, earn tax-deferred growth of the investment within the RRSP and later get it back at a presumably lower tax rate (i.e. when income in retirement is lower than working years). This is a product of having less debt, less mouths to feed, and less work-related expenses.
The RRSP is also a good savings tool when the individual has a low to average as tax bracket; money is put away for retirement, growing tax-deferred during these years. I still consider the RRSP as a good choice in this case as it creates a frame of mind where the account is set aside for retirement and can’t be used for anything else (like a family vacation or new car). Even if one’s future withdrawals are made at the same tax rate when you deposited the money there can still be value in the RRSP.
In the case of the RRSP, an individual will be taxed on the future withdrawals, so their tax refund is an interest-free loan on a future tax obligation. Therefore, one should do something productive with a refund from their tax return, for example, contributing to a TFSA or back into a RRSP. This allows one to “double dip” by getting the benefit of the RRSP along with building additional savings. Paying down existing debt would also be a beneficial use of one’s tax refund.
Saving for retirement in a TFSA is also a good choice for lower income earners. If using the TFSA, the temptation to withdraw funds for immediate spending should be minimized. The reality being that one should try to grow the account to the point where one can eventually live on future proceeds. Any short-term spending would slow that process down. Likewise, high income earners may also benefit from the growth of a TFSA on a tax free basis, but may wish to top up their RRSP first as a way to help reduce their yearly tax obligation.
Whatever the choice I would highly recommend speaking with a tax specialist along with a Wealth Advisor to help determine what option is best for your situation. Some people avoid the RRSP because they don’t understand how it can benefit them but it can be powerful if used properly. In short, proper advice and a successful investment plan can go a long way to achieving one’s retirement goals.
This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. Scotia Wealth Management is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.
Happy Investing,
Derek Fuchs Senior Wealth Advisor ScotiaMcLeod®, a division of Scotia Capital Inc. Scotia Wealth Management