Moneywise: RRSP or TFSA? Look at your tax rate

Moneywise: RRSP or TFSA? Look at your tax rate.

To put my money in a Registered Retirement Savings Plan (RRSP) or a Tax Free Savings Account (TFSA) may not be as dire a question as Hamlet asked himself (To Be or Not to Be?) in the famous Shakespeare play, but it’s nonetheless an important one that many Canadians may have been struggling with during the RRSP season and as they plan for their retirement.

The RRSP and the TFSA both are effective financial tools and strategies to set aside money but they serve different purposes and have different tax treatments which can determine which one is right for you.

“Generally we would say the best option is to maximize contributions to both,” says Myron Knodel, director of tax and estate planning with Investors Group.

“However not everyone is able to do that. In most cases some kind of blended approach incorporating both will probably be the most advantageous and make the most sense.”

In general, your marginal tax rate in the future will determine whether it’s better to invest in an RRSP versus a TFSA. Your marginal tax rate is tax on income including government-tested income such as the Old Age Security (OAS).

“If you expect that your tax rate will be lower when you retire than it is today, then an RRSP is probably the way to go,” says Knodel. “If, on the other hand, you expect to be in a higher tax bracket when you retire than you are now, then the TFSA is probably to route to take.”

The reason is that contributions and earnings accrued in your RRSP are not taxed until they are withdrawn, which usually is not until retirement, at which time you probably will be in a lower tax bracket than you were in your working years.

Additionally, contributions to your RRSP are eligible for a deduction which can reduce your income and tax payable.

Your personal contribution limit is based on your income, pension adjustments and how much you have contributed in previous years. You have to stop contributing to an RRSP on Dec. 31 of the year you turn 71.

Some people, however, may find that they expect to be in a higher tax bracket when they reach their retirement years than they were earlier in life.

This may include the self-employed or contract workers who come into money through an inheritance, the sale of a business or property or who may find a new, more lucrative career later in life.

A TFSA generally is more flexible than an RRSP, which carries heavy tax penalties if money is withdrawn early, and provides some interesting benefits for seniors.

Unlike RRSPs, there is no tax deduction for contributions to a TFSA. RRSP contributions are deductible and reduce your income for tax purposes. However, the money you contribute to your TFSA and growth through interest, dividends or capital gains are not taxable, except for any foreign tax on foreign investments. As well, your withdrawals are tax free.

Money in a TFSA can be invested in the same instruments as an RRSP such as stocks, bonds, GICs and mutual funds.

Any unused contribution room can be carried forward, and if you withdraw money in one year from the account, you are allowed to put it back but only in the year after it is withdrawn.

Money from a TFSA is excluded from income-tested benefits and tax credits such as the HST credit, OAS and the Guaranteed Income Supplement and will not reduce those benefits.

Unlike an RRSP, you can contribute to a TFSA after the age of 71.

As well, you can pass on your TFSA when you die. A spouse or common-law partner can be named as a successor holder, and upon the death of the TFSA owner the successor holder immediately becomes the new owner of the TFSA.

If the spouse is named the beneficiary of the TFSA, they can elect to transfer the assets at the owner’s death to their own account without affecting their contribution room. Any TFSA income earned after the death of the TFSA owner is taxable to the spouse.

“In the short-term the TFSA may seem be the most attractive option because of its flexibility, but if you have to make a choice it ultimately should be driven by the marginal tax rate you expect to be in in the future,” Knodel says.

Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors.

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