When it comes to investing, the first thing you need to figure out is what type of account is right for you. Here in Canada, there are three primary accounts you can use. RRSPs, TFSAs, and non-registered accounts. But how do you decide which one is best? That’s one of the most common questions I get asked, and so today I’m going to break it down for you. I’m only going to look at RRSP or TFSA because non-registered investment accounts only make sense if you’ve maxed out the other two.
RRSPs and TFSAs each have unique advantages and disadvantages, and your specific situation will affect which account is the right choice. Today we’re going to weigh the pros and cons to help you figure out where you should direct your money.
Registered Retirement Savings Plan (RRSP)
RRSPs are meant for retirement; it’s right there in the name. So that makes it simple right? If you’re saving for retirement, you should be using an RRSP. Well, not so fast.
The one thing everyone loves about RRSPs is the tax refund you get when you contribute. That’s what they are best known for. You make a deposit and then get money back at your marginal tax rate is. For example, let’s say your income is $150,000/year. That puts you in the 41% tax bracket. If you make an RRSP contribution of $10,000, your refund will be $4,100. Nice!
Take a look at the tax table below and see what your marginal tax bracket is:
2019 Tax Brackets (Alberta)
|Income||Tax Rate on Income|
|$0 - $12,069||0.00%|
|$12,070 - $19,369||15.00%|
|$19,370 - $47,630||25.00%|
|$47,631 - $95,259||30.50%|
|$95,260 - $131,200||36.00%|
|$131,201 - $147,667||38.00%|
|$147,668 - $157,464||41.00%|
|$157,465 - $209,952||42.00%|
|$209,953 - $210,371||43.00%|
|$210,372 - $314,928||47.00%|
The thing not everyone understands is that RRSPs are tax-deferred plans and not tax-free plans. You have to pay the tax eventually. Your money will sit in the account, and you won’t be on the hook every year for tax, but as soon as you start making withdrawals, you’ll get hit with a tax bill. Boo!
What’s the benefit then?
To get the benefit from an RRSP, you need to make your contributions when you’re in a higher tax bracket than when you’re making withdrawals.
Let’s use the above example to break this down. We’ll keep that same $10,000 contribution you made when you were in the 41% tax bracket. Flash forward to retirement, and we’ll assume your income is now $40,000/year. Your marginal tax bracket would drop to 25%. That’s now the tax rate you’d pay when withdrawing the funds. Removing that original $10,000 will result in a tax bill of $2,500. Ouch, but remember how you got a tax refund of $4,100? That difference of $1,600 is the benefit of an RRSP. And that’s just for one year’s contribution.
The reverse can also be true. If you start contributing to an RRSP when your income is low, there is a good chance you’ll end up adding when you’re in a lower bracket than when you retire. You’ll still get the refund this year and the deferred tax benefit, but you’ll end up paying more to withdraw the funds than you got to contribute them. Not ideal.
Lack of Flexibility
The problem with RRSPs is that they really are best when used for retirement. Sure, you’re technically allowed to make withdrawals at any point, but it rarely makes sense. Withdrawals from an RRSP have to be taxed, and it’s significant. For withdrawals less than $5,000 you pay 10 percent tax, between $5,000 and $15,000 it’s 20 percent tax, and withdrawals over $15,000 pay 30 percent tax. That’s a big hit on your savings
The other negative is that you only get a limited amount of contribution room in your life. You get 18 percent of your income in RRSP contribution room each year up to an annual maximum. In 2019 that maximum was $26,500. Once you’ve used the room, you never get it back, even if you make a withdrawal.
Basically, if you’re saving for anything other than retirement, then don’t use your RRSP. Unless…
The Home Buyer’s Plan Exception
There is one time when it does make sense to use your RRSP for a purpose that isn’t retirement. The Canadian government has a program for first time home buyers that allows them to withdraw up to $25,000* tax-free from their RRSP to buy a home. You’ll still get a refund when you contribute, but you’ll be able to withdraw the funds without having to send 10, 20, or 30 percent to the government.
*The 2019 budget proposed increasing this amount to $35,000
Every dollar counts when you’re trying to get into the housing market so that boost from the refund can go a long way when you’re saving your downpayment.
The catch is that you do have to repay the funds. The government gives you fifteen years to recontribute, starting the second year after you make the withdrawal. These aren’t considered new contributions, so you don’t get a refund again a second time. When you file your taxes, there will be a section to indicate your home buyers’ plan replacement amount.
Tax-Free Savings Account (TFSA)
And now to the newest addition to the Canadian registered plan family. RRSPs have been around for longer than almost all of your reading this (1957), but TFSAs were only introduced in 2009. In that short time, they’ve become incredibly popular because they provide investors with a tax advantage account with added flexibility.
Unlike an RRSP, you don’t get a tax refund when you contribute to a TFSA. Instead, your contributions grow tax-free, and there’s no tax due when you make withdrawals. That’s right. Once the money is in a TFSA, you NEVER have to pay tax on it. It might sound like a bummer that you don’t get the refund, but never having to pay tax has way more upside, especially for lower-income earners.
Let’s run the numbers! You could deposit $1,000 to your TFSA, buy a stock that skyrockets in value up to $10,000, sell it, and then withdraw that $10,000 and never pay a cent in capital gains. Outside of a TFSA, that kind of growth would cost you $1,845 in capital gains tax.
Sheltering as much of your non-registered money as possible within a TFSA can save you a lot of money in tax over your lifetime. And that’s why I always recommend maxing out your TFSA before investing in a non-registered account. The exception for that would be your emergency fund. Technically your emergency fund would be in a non-registered account, but because you’re not investing it (should be in high-interest savings), you shouldn’t be too worried about tax. You want your TFSA to grow, so don’t waste it by having it sit in cash earning next to nothing.
You only get a limited amount of TFSA contribution room each year. Unlike an RRSP, it is not based on your income. Every Canadian citizen who is over 18 years old gets the same amount of room annually. If you turned 18 after the 2009 date, then you would only have earn room starting the year you turned 18.
As of 2019, the total contribution room is $63,500. The yearly allowances have varied a bit so here’s the full breakdown:
|2009 - 2012||$5,000/year|
|2013 - 2014||$5,500/year|
|2016 - 2018||$5,500/year|
|2019 - 2020||$6,000/year|
The Flexibility Advantage
Because you never pay tax, you don’t have to worry about timing your TFSA contributions based on your income. This makes them a way better option for savings goals that aren’t retirement, or even for retirement when you’re not in your highest earning years. You can deposit and withdraw with no worries about the tax consequences.
Even better, you never lose your contribution room. If you make a withdrawal, you get to replace the full amount starting the following calendar year. If your timing is flexible, it makes sense to delay any withdrawals to later in the year so you can replace them in January.
So, RRSP or TFSA?
The answer depends on the purpose of the money you are saving. If you are saving for a shorter-term goal (buying a new car, going on vacation, etc.), then the TFSA is your best bet. It gives you the freedom to withdraw funds at any time without paying tax.
If you are instead saving for retirement, you then need to focus on tax rates. Will your current tax rate be higher than your tax rate in retirement? Most people’s incomes drop substantially in retirement, but there are exceptions. When you’re early in your career, you’re likely not earning as much as you will in the future. Use your TFSA and save your RRSP contribution room for when your income increases.
Or, if you’re working for a company that supplies a generous pension package, then your retirement income may not drop by much. I’ve seen quite a few people with pensions who end up staying in the same tax bracket for most of their lives.
Shorter-term savings goals = TFSA
Retirement savings and low income = TFSA
Retirement savings and high income = RRSP
Buying your first home = RRSP
These are general guidelines, and it certainly doesn’t have to be all or nothing. I split my monthly savings evenly between my TFSA and my RRSP. This allows me to get the benefits of both accounts and also designate savings specifically for retirement.
The ability to withdraw and recontribute to your TFSA also means you can move funds from your TFSA to your RRSP if your situation changes. Maybe you get big pay raise and now RRSPs make more sense, but you don’t have the funds to top-up right away. Move some money from your TFSA to your RRSP to take advantage. Most financial institutions will be able to make an ‘in-kind’ contribution. That means you won’t even have to sell any of the investments you hold. They’ll just pick them up and move them over to the RRSP.
If you’re still unsure, then I would always look to the TFSA first. You can’t go wrong, and you can always catch up on your RRSP later.
Need some help figuring out what’s best for you? Leave a comment, and I can help!
This post was proofread by Grammarly.