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RRSP or TFSA?

15 January 2015 by National Bank
rrsp or tfsa

Is it better to contribute to a registered retirement savings plan (RRSP) or a tax-free savings account (TFSA)? As one does not replace the other, the best solution is to contribute to both. However, each option has its pros and cons, depending on your age and personal financial situation.

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What is the difference between an RRSP and a TFSA?

These two savings vehicles meet different needs:

  • An RRSP is a long-term savings vehicle intended for retirement.
  • A TFSA is a complementary tool to help you save for short-term projects (e.g., travel, education, renovations). TFSAs can also be useful in saving for retirement as they do not affect the amount of government benefits you receive, unlike RRSPs.
  • RRSP contributions can be deducted from your taxable income, whereas TFSA contributions are made with income that has already been taxed. Therefore, they aren't tax deductible.

    That said, if you withdraw funds from an RRSP, they will be included in your taxable income and taxed at the rate in effect, which is not the case with a TFSA.

    Which one should you choose?

    As with any financial portfolio, diversification should be a key aspect of your retirement savings plans. Essentially, RRSPs and TFSAs enable you to build your tax-sheltered savings.

    Your financial planner can help you determine which one would be more advantageous in your situation. However, we've gathered a few rules of thumb for you below.

    If your tax rate is higher now than it will be at retirement, an RRSP is likely the better option. However, if you think that your retirement income will be higher than your current income, you're better off with a TFSA.

    "RRSPs offer two key advantages, but the biggest one is the tax savings," explained Jean-Philippe Bernard from National Bank Financial – Wealth Management. "RRSPs allow you to defer taxes on your investment income, while your contributions allow you to reduce your tax burden every year."

    Do you expect to receive a comfortable pension? Your government benefits (e.g., the Canada Pension Plan, Old Age Security and the Quebec Pension Plan) may be reduced as your pension income is considered in their calculations. Unlike with TFSAs, RRSP withdrawals are considered income. Therefore, a TFSA may be more advantageous as it enables you to better manage your total taxable income.

    If you are nearing retirement age, you must also take into account that at age 71, all RRSPs must be converted to Registered Retirement Income Funds (RRIFs), which will impact your taxes. This is not the case with TFSAs, which have no age limit, so you can contribute to them throughout your life. "In the case of RRSPs, your funds are tax-deferred, but the rate will likely be lower when you are 65 or 70 as your income is probably going to be lower," added Jean-Philippe Bernard. "As for TFSAs, you have already paid taxes on the funds invested, so you will not be taxed on them again when you withdraw them."

    When it comes to estate planning, there are also major differences between the two vehicles from a tax standpoint. Both savings vehicles allow you to designate a beneficiary. However, all amounts invested in an RRSP will be taxed upon your death, while with a TFSA, only increases in the value of your investments are subject to taxes.

    How to make contributions

    You can contribute up to 18% of your annual income to an RRSP, i.e., up to $24,370 in 2016, and up to $26,010 in 2017. You can exceed these amounts if you have unused contribution room from previous years.

    As for TFSAs, the maximum annual contribution may vary from year to year. You will find the allowable TFSA contribution room of the past years and prospects for next year via Canada Revenue Agency's web site. Any unused contribution room, starting in 2009, can be carried forward indefinitely.

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