Derek, should I invest in my RRSP or my TFSA?
This is a very common question at this time of year as investors scramble for a last minute deposit to their Registered Retirement Savings Plan (RRSP). The answer is not straightforward and depends on a number of personal factors. Before making the decision, it is important to understand the difference between the two accounts.
The TFSA is a useful account but operates under different rules than the RRSP. Unlike the RRSP, there is no annual deadline for the TFSA. There is also a new deposit limit available each year, regardless of what your income may be. In 2018 the new limit is $5,500 with a total limit of $57,500.
When you deposit money to your TFSA you will not be issued a tax-slip. This means that these deposits do not reduce your taxable income so there also will not be a tax refund from using the TFSA. The real benefit is that all future gains and withdrawals occur on a tax-free basis. When it does come time to use the money in your TFSA you can withdraw as you see necessary and it will not affect your taxable income, even if the money has grown substantially.
The RRSP does have an annual cut-off for deposits to count in the previous tax year. For this year the last day to contribute will be March 1, 2018. Your limit is unique to your income from the previous tax year, but is calculated as 18% of your previous year’s income less any pension adjustments. If you’re not sure, it may be best to refer to your Notice of Assessment provided to by the Canada Revenue Agency.
When you make a deposit to an RRSP you are issued a tax-slip which helps decrease your taxable income. This can be useful if you are in a higher tax bracket. The idea is that a deposit to your RRSP will lower your income so that you may end up paying less tax and get a refund when you file your taxes.
Once the money is in your RRSP, all interest and gains occur on a tax-deferred basis. When it eventually comes time to take the money out of your RRSP, the withdrawal amount is added to your annual income and taxed accordingly. In an ideal situation, you deposited the money to your RRSP when you were in a high tax bracket and are withdrawing the money at a low tax bracket. Despite this explanation it is best to talk to a qualified tax professional to confirm if the RRSP is right for you.
The choice between investing in a TFSA and an RRSP involves many factors. One factor to consider is what your tax rate is now, versus what it may be in retirement. If you expect that your tax rate in retirement will be lower, you may wish to use the RRSP since you can reduce your income at a higher rate, and withdraw it at a lower rate in the future. Your savings is the difference in your tax rate, plus the deferred growth. Consider all future sources of income at retirement to determine what your tax rate may be.
If you do deposit money to your RRSP, one consideration may be using your tax refund for something productive such as paying off debt or even investing back to your RRSP. Perhaps you could invest your refund in your TFSA to ensure that money won’t be taxed again.
If you’re already in a low tax bracket you may wish to save in your TFSA. Since reducing your taxable income is not a priority and your future withdrawals from your RRSP will be at the same low tax bracket the TFSA may provide you with a better savings platform. Remember that since you can take money from your TFSA without increasing your income that it provides you with flexibility in any given year without worrying about the tax implications.
Finally, remember that the decision does not have to be either the RRSP or the TFSA. In fact, some investors use both as their savings goals allow. Both types of accounts are unique and valuable so make the decision that is right for you. My best recommendation is to talk with a qualified professional to determine which account may make the most sense for you and speak with a Wealth Advisor to help make your investment plans.
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