The Canadian tax system allows us to make contributions to an RRSP in the first 60 days of 2011 and have the amount counted against our 2010 taxes. However with the introduction of Tax Free Savings Accounts in 2009, many of us may question whether to contribute to an RRSP or TFSA. Let’s consider the tax features and look at some examples of how each of these investments works in practice.
Like an RRSP, the interest, dividends, gains and losses that accrue within a TFSA are tax free. Unlike an RRSP there is no deduction from income on contributions to a TFSA. When money is removed from an RRSP the amount removed is subject to income tax. Since no deduction from income is allowed on contributions to a TFSA, amounts removed from a TFSA are not subject to income tax.
Let’s consider two different scenarios to help understand when one investment might be better than the other. Mike recently received a promotion and earns about $150,000. At this level of income Mike can expect to reduce his overall tax liability by $43.70 for every $100 he contributes to an RRSP. His investment will grow tax free while invested in a RRSP. Although Mike makes a comfortable wage now, he has no pension and will draw down his RRSP/RRIF in his retirement years. Mike’s annual cash requirement in retirement is expected to be a modest $35,000 per year. When Mike receives this income in his retirement years it will be his only source of income and will be subject to a lower rate of tax when compared to his current rate of tax. While there could be many other factors influencing Mike’s decision to contribute to an RRSP, his high level of income today, and his predicted lower level of income in his retirement years suggests Mike should contribute to an RRSP.
Now consider Lee who has just started a new business. While the business is in its growth stages Lee’s level of income is significantly less than Mike’s, about $40,000 per year. Lee can expect to reduce his overall tax liability by $22.00 for every $100 Lee contributes to an RRSP. A modest tax saving but not as good as what Mike is saving on his contributions.
Although Lee’s level of income is not significant today he expects to receive a large inheritance later in life. The interest and dividends generated on this inheritance will be enough to ensure he lives comfortably in his retirement years. Lee’s higher levels of income in retirement mean any amounts Lee removes from his RRSP/RRIF during his retirement will be subject to relatively higher rates of tax. In this example Lee’s relatively low tax savings on contributions to an RRSP, and relatively high rates of tax when he withdraws from an RRSP suggest contributions to a TFSA may make more sense.
There are other factors that should be considered when deciding whether to contribute to a RRSP or TFSA. Unlike an RRSP, which must be converted to a retirement income vehicle (usually a RRIF) at age 71, a TFSA does not have any minimum withdrawal requirement. RRSP and RRIF withdrawals are included in taxable income and effect the ability to collect income tested benefits like the GST/HST credit, Old Age Security, and the Guaranteed Income Supplement. TFSA withdrawals are not included in income and do not effect income tested benefits.
From these examples we can see the decision to contribute to an RRSP or TFSA will depend on many factors. I have discussed the more important tax considerations. There are many other factors to consider. Your financial advisor can assist you in the decision and ensure the type of RRSP or TFSA meets your overall financial goals. You should also discuss any planned contributions with your accountant to ensure you are not charged with penalties for over contributing.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.