The TFSA versus RRSP debate started in 2009 when the TFSA came into existence. Back then, the government allowed a $5,000 annual contribution and allowed you to do that every year.
It is also possible to go back every single year for your TFSA contribution. In other words, every year that you’ve been an adult you are accumulating room in your TFSA whether you use it or not. You will have that room next year, the year after, and the year after, or until the government decides to change those regulations.
Now if you decide to withdraw from a TFSA, there are some basic rules.
Let’s say you decide to withdraw money from a TFSA, so you pull the money out on March 5th. The following year on January 1st you will regain all of that contribution room back plus your new contribution room for the following year.
Here are some rules that you need to consider. Remember, you do not get a taxable benefit of any kind when contributing to a TFSA. You simply get the complete tax-free growth, meaning dividends, interest, income, capital gains, all of them are tax free for life.
The idea with the TFSA is you are setting up a liquid investment account that is producing tax free income. This is very useful in retirement, or very useful for your interest-bearing instruments. They could make a ton of sense inside of the TFSA.
With an RRSP, you make a contribution to your RRSP account which effectively reduces your taxable income by that amount in the calendar year you made the contribution.
The RRSP allows you to reduce your income. If you’re in a high marginal tax rate, that allows you to make a contribution and effectively get a ton of that money back via tax refund, or at least reduce your tax burden.
Let’s take a look at a couple scenarios and figure out what’s for you, a TFSA or a RRSP. Well, the problem is there is no easy answer, because every single human being in Canada is different.
From the list of factors that will matter in making the decision, the most important one is income. The higher your income, the better your likelihood is of making a RRSP contribution versus a TFSA.
Your age is also very, very important. The younger you are, the longer you have to defer your eventual income when you pull out your RRSP.
When you do pull out your RRSP in retirement you must convert your RRSP to a RRIF when you’re 71, but when you do withdraw that income, it is fully taxable as income, not the gains, not the income. The entire amount that you withdraw of an RRSP is taxable at retirement. So that’s one factor to consider.
If you’re young, you have a long window to get some tax regrowth in your RRSP and you don’t need to worry about paying the piper until much, much later in life.
Speaking of paying the piper at retirement, what is your expected income and tax rate?
Those are two huge factors that will impact whether or not you’re making RRSP or TFSA contributions.
What is your marital status. Are you able to benefit from a pension offset or a pension splitting of any kind through your RRIF? What are your liquidity needs?
Are you an entrepreneur who wants to have some capital because you want to invest in projects? Maybe you want to invest in real estate, or you need to have a nugget of liquid cash.
These factors – liquidity needs, age, income, income at retirement, investment horizon, marital status – all impact your desire, want, or need to contribute to your RRSP or TFSA.
A few general rules of thumb
- The higher your income, the more likely you are to make an RRSP contribution.
- The higher your liquidity need, the more likely you are to make a TFSA contribution.
- The closer you are to retirement, the more likely you are to make a TFSA contribution.
Which leads to this big one. If you’re expected to have no difference in your retirement age income and your working age income – in other words, your pension or other income from sources that you expect to continue – then the RRSP contribution makes slightly less sense as it’s less of an advantage to you because you’re paying tax today and you’re going to pay a high tax rate when you pull it out.
Therefore, the only gain is the deferral time for your RRSP contribution.
Let’s take a look at a couple scenarios.
Let’s say you’ve got a young couple making $30,000 each per year. For now, they should focus on TFSA contribution.
Say they’re able to save about $10,000- 12,000 per year. They both put in that amount, and max their contributions to their TFSA, and they now have access to that capital.
If their income increases next year or the year after to a significant number, say 50 60, 70 or 80,000, they can then withdraw it from the TFSA and put it into the RRSP and get the deduction.
Meanwhile, they got the tax-free growth in the TFSA for all those years.
Another scenario – let’s take a look at a 50-year-old professional couple, a doctor and lawyer say.
They’re both making $250,000 in their early fifties, they should definitely focus their expendable capital, their spare capital in an RRSP contribution.
They have 15 to 20 years before they need to draw on that income top tax bracket. They’re going to get a significant tax deduction by contribution to their RRSP. They then get to use that capital to do whatever they want with it.
They effectively get a tax refund for 50 cents on the dollar of their RRSP contribution. They get to contribute up to 18% of their income.
It’s a big contribution that they can make, and they can immediately benefit from that by having cash in their pocket.