Many of us have the good intention of saving, but don’t always know which option is best for our situation. RRSP OR TFSA? Is it better to contribute to a Registered Retirement Savings Plan(RRSP) or a Tax-Free Savings Account(TFSA)?
Yes, funds invested in an RRSP or TFSA grow tax-free while in the account. However, there are advantages and disadvantages to each of these options, which is why it’s important to know the differences between them so you can make an informed decision.
DIFFERENCE: CONTRIBUTIONS AND WITHDRAWALS
Assuming you have sufficient contribution room, the amounts you contribute to an RRSP are deducted from your income, saving you tax in the current year. The amounts you contribute to a TFSA are not deducted from your after-tax income.
On the other hand, amounts withdrawn from an RRSP are included in your income, while amounts withdrawn from a TFSA are not.
TAX SAVINGS: WHICH IS BETTER?
The answer depends on your marginal tax rate in the year of contribution versus your marginal tax rate in the year of withdrawal. If the rates for these years are equal, the two accounts are essentially equivalent in terms of tax savings, although because of the deduction, the RRSP will result in more money growing tax-free. If your marginal tax rate in the year of contribution is higher, you’ll probably be better off contributing to an RRSP. If the rate in the year of contribution is lower, you may be better off contributing to a TFSA.
Example
This year, you are in a 50% tax bracket. You contribute $2,000 to your RRSP, which saves you $1,000, so your net investment is $1,000 after tax.
You also contribute $1,000 to your TFSA. Since this amount is not deductible, your net investment is also $1,000 after tax.
Both amounts double in value in a future tax year. The value of the RRSP investment increases to $4,000 and the value of the TFSA investment increases to $2,000. You withdraw both amounts and are still in a 50% tax bracket. The amount withdrawn from the RRSP is subject to 50% tax, leaving you with a net amount of $2,000. However, the amount withdrawn from the TFSA is not included in your income, leaving you with a net amount of $2,000.
On the other hand, if your future tax rate is less than 50%, the net amount withdrawn from the RRSP will be greater than $2,000. If your future tax rate is higher than 50%, the net amount withdrawn from the RRSP will be less than $2,000.
CAUTION: EFFECTIVE TAX RATE AND ASSESSMENT RIGHTS
Finally, it’s important that you use your “effective” tax rate for the above purposes. For example, if your “basic” tax rate remains the same, but the amount withdrawn from the RRSP in the future year subjects you to the Old Age Security clawback rule, or reduces your age credit, your effective tax rate in the future year will be higher than your previous effective rate. In this case, investing in a TFSA would be more advantageous.
What’s more, TFSA contribution room can be reused from year to year. If you withdraw funds from your TFSA, your contribution room is increased by an equivalent amount on the following January 1. With an RRSP, the contribution room you build up each year is lost once you’ve used it, and you need additional “earned income” in subsequent years to build up new room. Therefore, if you plan to withdraw funds from your plan periodically, a TFSA is preferable.
Would you like the support of an expert to help you see things more clearly? Don’t hesitate to contact one of our tax professionals!
