Terry Tang, Investment Advisor
January 15, 2019
Should I invest in RRSP or TFSA first? This is a common question among Canadian investors. In my opinion, a better question to ask is “How do I utilize RRSP and TFSA in a more tax efficient manner?”, because they offers different tax advantages and it may make sense to get the best of both worlds.
Registered Retirement Savings Plan (RRSP) has been around since 1957. The objective of RRSP is clear; It is to encourage Canadians to save for their retirement by providing two tax advantages – tax deductions and tax deferral. While the latter may take years to realize, the former offers immediate benefit through lowered income tax, or in some cases a refund.
On the other hand, Tax-Free Savings Account (TFSA) is a general-purpose investment account designed to meet long-term savings goals. It gained popularity quickly after its inception simply because of the tax-free nature of the vehicle. However, there is a catch. The 2019 contribution limit for TFSA is $6,000, making the cumulative contribution limit to $63,500. This may not be much, especially for retirement savings, but it certainly offers a distinct advantage - 100 percent tax free on investment income. Unlike RRSP, TFSA contributions do not lower your annual tax bill.
Here are some important factors to consider when choosing between RRSP and TFSA.
Income Tax Bracket
Generally, one of the objectives of RRSP contribution is to drop to a lower tax bracket and reduce your tax bill. If your marginal tax rate is high, it makes sense to make RRSP contribution and minimize your taxes. This is especially true if your employer matches your RRSP contribution, because you would want to take advantage of the free money while lowering your taxes. However, the perceived benefit of RRSP contribution reduces when your marginal tax rate decreases.
TFSA generally offers greater flexibility when it comes to contributions and withdrawals. This is especially important when you have a short to mid-term investment time horizon. Assets can be withdrawn from TFSA tax-free, where as withdrawals from RRSP would be subjected to income tax. But keep in mind that flexibility is a double-edged sword. Investors may be tempted to withdraw assets early, thus compromising their investment goals.
Purchasing A Home
If you are planning on buying a home for the first time, you may want to consider making RRSP contributions. The Home Buyer’s Plan (HBP) allows Canadians to withdraw up to $25,000 towards purchasing. This amount may not be much by today’s standard, but the advantages are apparent; As usual, the contribution can be used towards reducing your taxes, and the HBP withdrawal is tax free. However, you are required to repay the HBP withdrawal and have up to 15 years to do so.
If you do not want the commitment of repaying the HBP, TFSA may be a better option.
For someone who expects to receive very modest retirement income, it may be the case that the perceived benefit of RRSP contribution is significantly reduced. This is because the government takes into account your RRSP (or RRIF) withdrawals when determining your Old Age Security (OAS) and Guaranteed Income Supplement (GIS) payment, but not TFSA. For 2019, the maximum OAS income is $601.45 per month and clawback starts when net income exceeds $77,580.
The views and opinions expressed are those of the author and may not necessarily be those of Aligned Capital Partners Inc. The content is for informational purposes only and not meant to be personalized investment advice.