Registered retirement savings plans, known as RRSPs, and tax-free savings accounts, referred to commonly as TFSAs, are the two most widely used, tax-advantaged savings programs for Canadian taxpayers.
Which is the better choice? There is no right answer. I like them both. They are valuable savings vehicles but they have different features. Let’s have a look.
An RRSP is a retirement savings plan that is registered with the Canada Revenue Agency. You make contributions to the plan as you wish, but your annual contributions are subject to the lesser of: an annual limit (currently at $26,500 for 2019) and 18 per cent of your earned income (which is primarily employment income, net self-employment income and some other non-investment sources).
You can manage the plan yourself or have a portfolio manager or a robo-adviser manage it for you. You can invest in a wide range of investment products including bonds, common and preferred shares, mutual funds, exchange traded funds and others.
An RRSP has two key features.
The first is a current tax deduction. Your contribution is tax-deductible for the taxation year it is made.
So if you contribute $5,000 to your plan in 2019 and your marginal tax rate is 30 per cent, you will get a $1,500 tax savings for the taxation year. (The marginal tax rate is the rate of combined federal and provincial tax you pay on an additional dollar of income.)
The second feature is that it takes advantage of the magic of tax-free compounding. Since your investments in your RRSP grow tax-free, your interest, dividends and capital gains are not taxed within the plan.
If, for example, you contribute $5,000 to your RRSP at the start of the year in 2019 and your combined interest, dividend and capital growth for the year is eight per cent, your RRSP will be worth $5,400 at the end of the year.
If in 2020, your RRSP investments grow by six per cent (not including any further contributions), your RRSP will be worth $5,724 ($5,400 x 1.06) by the end of 2020, and so on.
An added benefit of an RRSP is that there is not a minimum age requirement for investing. If your child has earned income, they can contribute to an RRSP. If they have a summer job when they are 14 and earn some income, they will be eligible to start the compounding process at an early age.
However, it’s not a completely free lunch. You have to pay tax when you receive payments from the plan upon retirement. If you cash in early, there will be a tax bite — possibly a large one, if it’s during a period in which your income is high.
You can choose the date that you want to collapse your plan, although your RRSP must mature by Dec. 31 of the year when you turn 71.
You can simply take the cash value (this is terrible choice since the whole amount will be taxable), buy a life annuity or convert your RRSP to a Registered Retirement Income Fund, or an RRIF. The RRIF is the most popular choice. Your annual withdrawals from the RRIF (there is a minimum requirement) will be taxable in the year of withdrawal.
The TFSA program was introduced in 2009. You make contributions to the plan as you wish, although your contributions are subject to an annual contribution limit ($6,000 for 2019).
As with the RRSP, you can manage it yourself or have someone manage it for you, and you can invest in the same wide range of investment products as the RRSP.
Unlike the RRSP, your annual contributions are not tax-deductible, however the proceeds are never taxable. Similar to the RRSP, your investments in the TFSA grow tax-free. But unfortunately, your child has to wait until they reach the age of 18 before they can contribute.
Both tax savings plans are valuable, and if you have the funds available to invest the maximum (a total of $32,500 in 2019), I would generally recommend that you max out your contributions.
However, most taxpayer/investors have to choose how they will invest.
How to choose
Here are some considerations:
The usual choice is to contribute to an RRSP to get both the tax deduction and the tax-free compounding benefits.
This option works best if your current marginal tax rate is relatively high and you expect it will be lower when your plan matures. You get the tax break now, and pay a lower rate of tax when it matures.
On the other hand, if your income and tax rate are relatively high when your RRSP matures, you will pay a high rate of tax on the annual withdrawals from your RRIF (assuming you convert to a RRIF). You might also lose other benefits such as the Old Age Security Supplement which could be clawed back if your income is too high.
If your employer is offering a contribution match for your RRSP — take it! That’s an easy choice.
The TFSA does not provide for a tax deduction, but it offers convenience. You can withdraw money from the account without incurring taxes. If you are young and your current income level is low, the TFSA might be the better choice for the enhanced flexibility.
You can use your account for some particular short-term use such as the downpayment on a house.
Build savings into your budget
Consider using a periodic purchase plan where you direct a specific amount per month to be contributed from your bank account to your RRSP or TFSA. This results in savings being built into your budget.
If you are looking for a disciplined approach, you can contribute what you can to an RRSP each year, and then put your RRSP tax refund into a TFSA.
The bottom line — it’s never too early nor too late to start your saving program. Whether it’s an RRSP, a TSFA or preferably both, they are both important and easy ways to help you work toward achieving your financial goals.
By: Eric Kirzner
John H. Watson Chair Emeritus in Value Investing, University of Toronto
Eric Kirzner does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.