It’s time to make a contribution toward your retirement and other savings goals. It’s a perennial challenge for many Canadians — contribute to a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA). Ideally, you should be making regular contributions to one or both throughout the year as part of a plan you’ve worked out with a financial advisor. If, however, you have some extra cash available, let’s summarize the pros and cons of each option.
RRSP contribution limits for Canadians continue to increase every year. Your allowable contribution is 18% of your earned income from the previous year to a maximum of $24,270 for 2014, $24,930 for 2015 and $25,370 for 2016. You may also be able to tap into any unused contribution room you have carried forward from previous tax years.
That allowable contribution is deducted from your gross taxable income for the year and you may end up with a tax refund (which many recommend putting right back into your RRSP for next year or even a portion into your TFSA). This makes an RRSP an ideal choice for savings especially for high-income earners.
On the other hand, an RRSP only defers payment of income tax until your retirement years. Forced annual withdrawal amounts after age 71 may also reduce government old age benefits. Those with a rich pension plan, working in retirement or major sources of alternative income may want to consider additional savings options, such as a TFSA, in consultation with a financial advisor.
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The TFSA is an all-purpose way to invest because it can be used to save for any financial goal. Canadians can invest up to $5,500 annually and carry-forward any unused contribution room. While that annual contribution is not tax-deductible, any growth in your TFSA investments is sheltered from taxation even when money is withdrawn.
Unlike the RRSP, you can withdraw TFSA money without paying tax at any time and, best of all, the full amount of any withdrawals can be put back into your TFSA in future years (but not the same year). So, if your $5,500 investment grows to $10,000 and you withdraw it tax-free, you can turn around the next year and put $10,000 (plus another $5,500) back into your TFSA to continue growing.
Also, unlike the RRSP, income earned in a TFSA and amounts withdrawn do not affect your eligibility for federal income-tested benefits and credits such as Old Age Security or the Canada Child Tax Benefit. As well, unlike the RRSP, you don’t have to withdraw any money from your TFSA after age 71, so it is a effective savings tool for seniors.
The chief disadvantage to a TFSA is that your contributions are not tax-deductible so you don’t receive the immediate tax benefit seen with an RRSP. There is also no such thing as a TFSA spousal plan, but you can still give your spouse or common-law partner money to invest in their own TFSA, and the income earned on the contributed amount is not attributed back to you.
The Bottom Line
The RRSP continues to make good sense as a first savings option for many investors. That said, a TFSA offers interesting investment opportunities for high-income earners, those nearing retirement as well as seniors. It may also be valuable to investors with lower incomes or those needing to access cash at any moment without penalty.
A financial advisor can show you how TFSAs and RRSPs can provide you with plenty of flexibility in terms of savings opportunities and the capability to safely access money for emergencies.
Deborah Leahy is an Investment Advisor with Edward Jones, Member Canadian Investor Protection Fund