With the RRSP contribution deadline approaching, there’s lots of pressure to contribute to an RRSP because of the tax deduction. But should you contribute to a TFSA instead because of the completely tax-free growth it offers?
The answer depends on two basic questions: What is your marginal tax rate when you contribute to an RRSP? What will your marginal tax rate be when you withdraw the money from your RRSP?
Most people assume that when they retire, they will be in a lower tax bracket. If you expect to be in a similar or even higher tax bracket in retirement as you are when you’re working, then it might make more sense to load up your Tax-Free Savings Account (TFSA) to the maximum levels each year, because in a TFSA, the money will not be taxed when withdrawn.
How TFSAs work
A TFSA, remember, lets you contribute a maximum $5,500 annually (as of 2015), regardless of your income or pension plan or anything else. You have to be over 18 and a have a valid Canadian Social Insurance Number. That’s it. In addition, if you don’t contribute to your TFSA in a given year, you may carry that unused “contribution room” forward to be used in future years to use above and beyond maximum contributions. There’s no tax deduction for contributions, but the whole beauty of the TFSA is that investment income generated within the plan – whether interest, dividends, or capital gains – is completely tax-free.
If you haven’t opened a TFSA, and you’re eligible to do so now, you may in 2015 immediately contribute your entire accumulated contribution room since 2009 – that’s $36,500. And the next year, you’ll be able to add another $5,500. And so on. And so on. The maximum contribution is also indexed to inflation, so from time to time, the amount is increased. It was last increased in 2013, to $5,500 from $5,000.
Here’s how Canada Revenue Agency calculates your unused TFSA contribution room:
The amount, either positive or negative, at the end of a particular calendar year after 2008, determined by your unused TFSA contribution room at the end of the year preceding the particular year,
Plus:
the total amount of all withdrawals made from your TFSA in the preceding calendar year, excluding a qualifying transfer or a specified distribution;
the TFSA dollar limit for the particular year if, at some point in that year, the you are at least 18 years old and a resident of Canada. In all other cases, the amount is nil.
Minus:
The total of all TFSA contributions made by the holder in the particular year excluding a qualifying transfer or an exempt contribution.
A “qualifying transfer” is essentially a direct transfer between your TFSAs if you have more than one plan. An exempt contribution is basically a contribution made during the rollover period after the death of a TFSA holder, from payments received from the deceased holder’s TFSA.
RRSP withdrawals are taxable
With an RRSP, you get a tax deduction for contributions you make, and money in the RRSP grows tax-free until you withdraw. Withdrawals from your RRSP are taxable at your marginal rate at the time of withdrawal, so if you expect to be in the same tax bracket at retirement as you are now, then you’ll pay tax on withdrawals at the same rate as you do now. At maturity, you can, of course, roll over your RRSP into an annuity (very low rates at present) or another plan, like a Registered Retirement Income Fund (where withdrawals are still taxed at your marginal rate), but this is another story.
When withdrawing from an RRSP at retirement, you will generally want to make sure that you keep your income below the Old Age Security income threshold, or your OAS benefit will be “clawed back.” Essentially you would be giving “free” money back to the government.
Contributions to a TFSA, on the other hand, do not give you any tax deduction or credit. And contribution limits, and thus tax deductions, are much higher for an RRSP. However, money in a TFSA grows tax-free, and withdrawals, which can be made at any time, are also tax-free. In addition, withdrawals from a TFSA at retirement have no effect on your eligibility for federal income-tested benefits, such as Old Age Security.
My advice is to use a combination of TFSAs, RRSPs, and non-registered accounts. Meet with a financial planner to create a plan that will help you maximize your income in the most tax-efficient way in retirement.
