1 in 4 Canadians don't understand the difference between Tax-Free Savings Account (TFSAs) and Registered Retirement Savings Plan (RRSPs), even though they should both be crucial parts of any investment strategy.
Read on to see what these two investment vehicles are all about and how you can include them in your comprehensive savings plan.
What Is a TFSA?
A TFSA is an investment vehicle that was introduced by the Canadian government in 2009. So it's relatively new.
If you are using your TFSA as a savings account, as its name indicates, you may want to rethink your strategy. TFSAs offer a variety of tools for capital appreciation, like assets purchasable on the stock or bond markets and GICs. All the profit you gain will not be taxed, this being the main selling point of this registered account. While you can use your TFSA as a savings account with a bank, the interest rate you would earn on your contributed amount is likely to be much lower than your potential returns through investing.
There are still some benefits to having at least a small part of your TFSA in a bank savings account, because you will have quick access to your money in case you need it urgently and it will always be earning interest (although at a low rate) regardless of stock market fluctuations. There's no limit to how many TFSA accounts you can hold, however there's a limit to how much you can contribute each year across all of your accounts.
TFSA accounts have a specific contribution limit per year. If you were 18 or over in 2009, you have $75,500 in total contribution room available to you in 2021, if you have never contributed. To help you figure out your current contribution room limit, we suggest you refer to this chart, or search for TFSA contribution room calculator online. Each year you may only contribute the maximum allowed amount for that specific year (in 2021, it's $6,000). If you withdraw any funds from your TFSA, you may recontribute them, but only in the following year. It may get confusing trying to figure out your contribution limit, so we suggest to use the two previously mentioned resources to keep track of all your contributions. CRA will also provide you with your contribution room on your Notice of Assessment.
It's also important not to overcontribute to your TFSA as the amount over the limit will be taxed at 1% monthly until it is withdrawn from the account.
Tax-Free Gains and Sticking It to the Tax Man
The brilliant thing about TFSAs that most people don't understand is that you've already paid taxes on the money you put into it. What does this mean?
Of course, your money has already been taxed before you put it into your TFSA, so the tax man already got his share. But at least it won't be taxed again when you increase your wealth through investments or earned interest; this is actually a pretty great deal for Canadians.
Anything and everything you earn in interest inside a TFSA is tax-free. You receive big breaks in the future because you won't have to pay anything when you take profits and withdraw your money. This is a costly operation for the government, for instance the one-off $10,000 contribution limit increase in 2015 is said to have cost $1.1 billion in lost tax revenue.
It's Easy to Open a TFSA and Start Contributing
If you don't have a TFSA already, it's easy to setup. Most financial institutions, credit unions, or even insurance companies will be able to help you with that.
You need to be 18 years old or older, and have a valid social insurance number (SIN) to open a TFSA.
The main thing you need to think about is what kind of investments you wish to hold within your TFSA. It is advisable to hold stocks or GICs in them, but it depends on your retirement strategy and risk levels.
TFSA Limitations and Some Things to Be Careful Of
Most Canadians don't think twice about taking money in and out of their TFSAs, but that's something to be careful about.
For one, you might unintentionally overcontribute which can result in a 1% monthly penalty fee on your contributions until you withdraw the excess amount. If you have multiple TFSA accounts, make sure to record your contributions diligently. As mentioned previously, also be careful not to recontribute your withdrawals in the same year that the withdrawals were made.
Ensure you only contribute the limit each year (it's $6,000 for 2021). Also, be careful of your residency status. If you lose your resident status, you will be charged a 1% monthly tax on those contributions until you withdraw.
You can't day-trade stocks in your TFSA account.
What Is an RRSP?
RRSPs are the long-term retirement savings accounts that most Canadians are familiar with. Many workplaces offer Group RRSP plans, or matching plans, where they will match your full contribution or a percentage of it up to a certain limit.
For 2021, the RRSP contribution limit is 18% of your reported income during the previous year or $27,830, whichever is the lesser amount.
If your workplace doesn't offer a matching RRSP contribution plan, it's still wise to have this account as it may help you reduce your current tax burden as well as provide funds for your retirement.
The main benefit of RRSPs is that you can defer taxes on RRSP contributions and capital appreciation until withdrawal time.
Tax Deferral Doesn't Mean Tax-Free
For example, you made $70,000 in 2020, your maximum allowable deduction (that's what RRSP contributions are called) is $12,600 (18% of $70,000) for the 2021 tax year. If you earn $70,000 in income this year as well, and make your maximum allowed contribution, your total reported taxable income for 2021 tax year would be $57,400 ($70,000 minus $12,600).
That's what it means to defer your taxes. It's not tax-free by any means, though. You just end up paying those taxes much later, which could be advantageous as you would likely be in a smaller tax bracket once retired.
It could get confusing calculating your maximum allowed deduction, this is why the CRA kindly informs you of it on your Notice of Assessment.
Since likely you won't be earning income in retirement (or earning less income), you'll be in a lower tax bracket, meaning you get to keep more of your account's withdrawals for yourself.
You can start making withdrawals from your RRSP at as early as 55 by converting your account into a RRIF (Registered Income Retirement Fund), however most people prefer to wait longer as you could run out of funds before your death.
There are also other ways you can withdraw cash from an RRSP:
- Home Buyers' Plan (HBP) allows you to withdraw up to $35,000 from your RRSP towards buying or building a home (you have to pay it back within 15 years)
- Lifelong Learning Plan allows you to withdraw up to $10,000 in a year to finance full-time education or training for you or your spouse, you'll have up to 10 years to repay these withdrawals
The government has tried to make RRSP accounts a full solution for Canadians to fund their retirement so you don't rely wholly on the old-age pensions to support you.
Should I Get a TFSA or an RRSP?
This is the question that is probably swimming around in your brain right now. Should you contribute to a TFSA or an RRSP? Is one better than the other?
The answer is no. One isn't better than the other as an investment vehicle, because both accounts serve their specific purpose in your long-term investment and savings strategy.
Ideally, you would max out both accounts every year, but that is not easy to achieve with limited income unless you're ready to give up a significant portion of your earnings to safe for your future.
If you would have to pick one, TFSA should be your priority because of its tax-free component. However, if your earnings allow, start contributing to your RRSP as soon as you max out your available TFSA contribution room.
If your employer offers matching RRSP contributions, then your priorities could be different. Depending on your how advantageous your employer's RRSP plan is, your could consider prioritizing it over your TFSA.
Also, don't forget that you can withdraw from TFSA at any time, for emergencies, or for other expenses. However, since you can't withdraw from your RRSP before you turn 55, it forces you to save for your future. Take this information into consideration when deciding which account to prioritize.
Either way, you should try as much as possible to contribute the maximum allowed amount to both your TFSA and RRSP.
Know Your Tax Bracket before Withdrawing from Either RRSP and TFSA
Since TFSA withdrawals aren't considered taxable income, they don't affect your eligibility for certain government benefits, like Old Age Security (OAS).
For your RRSP withdrawals, be mindful of your federal and provincial tax brackets. You can combine your RRSP and TFSA withdrawals to generate your retirement income in a very tax efficient way.
Taxes, RSSPs, TFSAs, and other government benefits can get pretty complicated, even though the Canadian government doesn't think so. If you're confused by information presented in this article, your best bet would be to get professional help from a financial advisor to clarify all of your choices.
TFSA Vs. RRSP - What's the Best Choice for You?
The TFSA vs. RRSP debate is popular among Canadians, and many Canadians are stumbling about in this confusion. This article should have given you the basics in figuring out what choices to make.
The good news is that as long as you are investing for the future and making sound fiscal decisions, you should be all set in the long run even if you weren't choosing to make your contributions to the most beneficial registered account for your situation. Both accounts are amazing savings vehicles.
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