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A Brief Recap of RRSP and TFSA

Let’s start with a brief recap of the features of RRSP and TFSA: They are both very good vehicles for saving for one’s retirement.

  • Within a certain limit, contributions made to an RRSP account are tax-deductible, thus reducing one’s current tax liabilities, and the investment in the RRSP account can grow and accumulate free of any taxes. Withdrawals from it will be considered taxable income and taxed accordingly.
  • TFSA is the mirror-image of RRSP. While contributions made into a TFSA account are from after-tax dollars, the earnings and gains in the account can accumulate without any tax consequences for the account holder. What’s even better, you can withdraw from that TFSA account any day you feel like it and the taxmen will not touch a penny of it. This might be the only time in your life when your earnings and gains are protected from the taxman.

When to Max Your RRSP and TFSA Accounts

If you are making enough money and can resist the temptation of spending it all and save enough to top up your RRSP and TFSA, do not hesitate and do it now.

But you heard some people say that your GIS will be affected in your retirement if you have income from an RRSP? GIS is income-tested and one can easily become ineligible. If you know for sure, despite the income you are currently making, that you will be entitled to OAS and GIS if you do not have much other taxable income in your retirement, there is a very simple solution. Quit working just a tad bit earlier than you otherwise would and make withdrawals from your RRSP account so that you get taxed before your expected retirement. Or you might feel like going on vacation for an extended period of time, say a year or two, which you would normally be unable afford. Withdraw money from your RRSP account and go take that vacation!

When TFSA Is Better

At the risk of oversimplifying, if your taxable income is no more than $44,701 (which is the lower limit of the second federal tax bracket for 2015), you might be better off contributing to a TFSA account. Taxable withdrawals from an RRSP account or an RRIF might affect your eligibility for GIS. If you are expecting to make more later in your working life, the unused RRSP contribution room will become handy when you can save more in taxes by contributing to your RRSP at that time. 

When RRSP Is Better

If your taxable income falls under the second or third tax bracket, the tax savings might make it meaningful enough to make contributions. But be sure not to spend that tax savings, but rather save it, preferably in a TFSA account! If the tax savings are spent, the fact that RRSP or RRIF withdrawals are taxable will make it less desirable than TFSA!

Let’s say you make an RRSP contribution of 5000 dollars, and doing that saves you 2100 dollars in taxes your marginal tax rate being 42%). With those 2200 dollars in tax savings, there are two possible ways of using it :
1) you can spend it, say go on a vacation, which you deserve;
2) or you can put 2200 $ in a TFSA account for a rainy day.

Let’s have a see where those two financial decisions lead you.

For this example, we make two assumptions:
1) that your investments grow at a 10% annual compounding rate (meaning your money is increased by 10% every year against the principal + earnings total of the previous year). As an example, 100 dollars at the beginning of Year 1, grows to 110$ at the end of Year 1; at the end of Year 2, the 110$ grows to 110 * 1.10% = 121 $. And so on so forth.
2) that your marginal tax rate stays the same at 42%.

Choice one: your RRSP account grows (suppose the 5000$ is the only contribution made) for 10 years and at end of year 10, reaches 5000 * (1+10%)^10 = 12,968.71$. When you withdraw the entire amount, you get $7,521.85.

If the after tax amount had been invested in a TFSA account, you will end up with the same $7,521.85.

Choice two: Besides the $ 7,521.85 you net from the RRSP account, your 2,100 $ contribution to the TFSA accounts grows to $5,446.86. That’s over 70% more than just your RRSP savings!

When you need to buy your first home, or go back to school, you can make withdrawals out of your RRSP account and pay that money back without having to pay taxes (certain conditions apply).

Please note that whatever is discussed above is a generalization and is not expected to be considered fit for any specific situation. And this should never be considered investment or tax advice, though it may appear so. Professional advice should always be sought for any real life situations.

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