For many Canadians, saving for important life goals can feel like an uphill struggle. But it doesn't have to be. There are tax-efficient structures in place to give Canadians of all ages a bit of tailwind help - but too few of us are taking advantage of them.
The most popular are Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs). Both are excellent tools, and when you know their key differences, you can use either or both to help you create wealth more effectively.
Here's why: Canadians pay taxes on investment income, and while the tax bill will vary depending on your tax bracket and whether it's income from interest, dividends or capital gains, taxes create a drag on your ability to take advantage of the power of compounding. This can make a difference of tens, if not hundreds of thousands of dollars in your pocket over your lifetime.
Here's a list of differences between RRSPs and TFSAs to help you decide which one makes more sense for you:
WHEN RRSPS MAKE SENSE OVER TFSAS
Contributing to an RRSP lowers your immediate taxable income
Investing in an RRSP gives you a tax deduction up front. The higher your income bracket, the greater the tax benefit you'll receive as a result of your contribution.
Also, because any unused contribution room can be carried forward, there's an opportunity to be strategic and contribute more in the years your income is higher, and less when you expect to be in a lower income tax bracket.
There are no tax-deduction benefits when you contribute to a TFSA.
RRSPs typically have higher contribution limits
Your RRSP contribution limit for 2020 is 18% of the earned income you reported on your 2019 tax return, up to a maximum of $27,230. Your TSFA limit for the 2021 calendar year is $6,000.
RRSPs can be family-sized
Spousal RRSPs allow you to reduce your tax liability now and in the future by splitting your income with your partner.
For example, if you earn more than your spouse or common-law partner, you can contribute up to your allowable limit to their plan under a Spousal RRSP. You get the benefit of the higher tax deduction now and when your spouse or partner withdraws money from the plan in the future, they'll be taxed at their tax rate, which will hopefully be lower than yours.
With a TFSA, there's nothing stopping you from contributing to your spouse's plan. But there are no tax benefits in doing so, since TFSA contributions are made with after-tax dollars.
WHEN TFSAS MAKE SENSE OVER RRSPS
TFSAs offer more flexibility
TFSAs can be used for any type of savings goal while an RRSP is really intended for retirement savings.
That's why you can withdraw money anytime from your TFSA without any penalties or tax implications. And you won't lose contribution room when you do.
While there's no penalty if you withdraw from your RRSP early, you will be taxed: every withdrawal is subject to withholding tax and income tax and - worse-the contribution room will be lost for good. The two exceptions: you can borrow from your RRSP tax-free and interest-free to purchase a first home (Home Buyers' Plan) or to pay for your own education (Lifelong Learning Plan).
The tax-advantages of TFSAs don't expire
You can contribute to a TFSA for as long as you live and continue to build wealth on a tax-free basis.
RRSPs, on the other hand, expire at the end of the year you turn 71, when you're forced to convert it into a Registered Retirement Income Fund (RRIF) or buy an annuity. Most people convert their RRSP to a RRIF and start drawing a regular income based on a formula. At this point, the tax-deferment for that portion ends and any income withdrawn will be subject to tax at your marginal tax rate.
TFSA withdrawals in retirement don't affect your Government benefits
That's not the case with your RRSP or RRIF. The income you draw from the RRSP or RRIF in retirement affects your Government income-tested benefits. which means benefits like Old Age Security (OAS), Guaranteed Income Supplement (GIS) and Employment Insurance (EI) payments can be clawed back.
While there are pros and cons to RRSPs and TFSAs, I'll leave you with this thought: most people can't say for certain what their personal tax situation and Canada's tax rates or laws will be 10, 20 or 30 years from now. That's why - if you can swing it - it's worth using both to take advantage of the power of compounding and make more of your money work for you.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.