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Should I contribute to an RRSP or TFSA?

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Imagine earning money but not paying income tax on it. Or buying something and not paying sales tax. With registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs), you don’t have to pay tax on your investment earnings — and with an RRSP, you even get a tax deduction when you contribute.

So, should you contribute to an RRSP or TFSA? There’s no one-size-fits-all answer: both options can boost savings and help lower the amount of tax you pay.

Anyone who has a social insurance number (SIN) and files an income tax return in Canada can open an RRSP account and contribute to it, as long as they earned income in a previous year and have RRSP contribution room available to them.

Anyone who has a valid SIN and is 18 or older can open a TFSA account. You don’t need to earn income to contribute, but you can contribute only up to your TFSA limit for the year.

Whether you contribute to one or the other (or both!), you can maximize their benefits by using RRSPs and TFSAs in strategic ways, which may change at each stage of your life and career. An MD Advisor* can help determine the best strategy for you.

RRSPs and TFSAs: A few things in common

An RRSP and a TFSA are both investment accounts, registered with the Canada Revenue Agency (CRA), that offer extra tax benefits as an incentive for Canadians to save more money.

You can save a significant amount. Both accounts allow you to contribute up to a maximum amount for each tax year.

  • The annual TFSA limit for everyone is $6,000 in 2021. However, your personal contribution has been accumulating since 2009 (for every year that you were eligible). If you have never contributed, you may be able to put in up to $75,500 in 2021.
  • RRSP contribution room depends on your earned income and other factors. In general, for 2021, it’s 18% of the previous year’s earned income to a maximum of $27,830. Like the TFSA, unused room from previous years is carried forward. Look for your RRSP contribution limit on your most recent notice of assessment from the CRA.

You can top up anytime. You can always “catch up” later, when you’re earning more. If you don’t contribute to an RRSP or a TFSA this year, you can carry over unused contribution room to future years.

You can invest these funds however you like. Both types of accounts allow you to invest your contributions within them in a wide range of qualified investments such as stocks, mutual funds, exchange-traded funds (ETFs) and term deposits. However, some investments are better suited for RRSP or TFSA accounts than others — you may wish to get guidance from a financial advisor before investing.

You can reduce your taxes. Both of these savings vehicles offer tax incentives — but in very different ways. The key difference is in how each account treats contributions and withdrawals.

RRSPs: Save now, but pay income tax later

There’s a tax deduction on contributions. The amount you contribute can be deducted from your earned income in the year you claim it (up to your maximum contribution room) for income tax purposes. This may result in a tax refund for you.

Investments are tax sheltered until you withdraw. So long as your savings are left inside an RRSP account, investments can grow tax-free. RRSP withdrawals are treated the same as other pre-tax income, however, and are fully taxable. So, you’ll eventually pay taxes, but the idea is to hold off withdrawals until retirement, when you’ll likely be in a lower tax bracket than you were through most of your career.

You can dip in for a down payment or studies. You can access limited amounts tax-free in an RRSP for certain uses, provided you repay the money over time. The federal government allows withdrawal of up to $35,000 for a down payment on a home, through the federal Home Buyers’ Plan, or up to $20,000 to finance full-time training for yourself or your spouse, through the Lifelong Learning Plan.

You can withdraw anytime and be taxed — if it makes sense that year. Although the RRSP was introduced as a retirement savings account, it can be useful to withdraw funds during any period of lower income in your career — such as a parental leave or if you take time off to volunteer — when you’re in a lower tax bracket. Note that withdrawals do not result in recontribution room like they do for TFSAs.

You can use a spousal RRSPs as an income splitting tool. If you earn more income than your spouse or common-law partner does, you can contribute to a spousal RRSP in their name. They will withdraw the funds in retirement, and you will get the deduction for contributing now.  Take a closer look at this tax-saving strategy.

TFSAs: Investments can grow, tax-free

There is no deduction on contributions. You don’t get a tax deduction (or the possibility of generating a tax refund) when you contribute to a TFSA — unlike an RRSP.

You keep everything your investments earn. You can’t use a TFSA to reduce income tax, since you fund it with after-tax dollars. But once you’ve contributed to your account, you get to keep every dollar earned. You won’t pay tax on interest income, dividends or any capital gains.**

There’s no tax on withdrawals. You can take money out anytime, and there’s no tax or penalties on withdrawals. Money from your TFSA does not count as income and does not trigger any taxation. Also, withdrawals from your TFSA don’t affect how much Old Age Security, Guaranteed Income Supplement or Employment Insurance you receive.

You can recontribute after withdrawing. If you withdraw funds from your TFSA, you’re allowed to recontribute that amount in the future — the amount withdrawn will be added back into your contribution room the following calendar year.

A smart tax strategy: Allowing you to save at the right time

Whether you save and invest within an RRSP, TFSA or both, you’ll benefit from the power of compounding. The money earns a return, and your money grows faster when it earns a return on the return — especially when you don’t have to pay tax on the returns each year.

Both types of registered savings accounts can be used to boost the effectiveness of your financial planning over time. The optimum amount to contribute to your RRSP or TFSA, or both, each year may shift as your family grows or your practice changes. If you’re not in a financial position to contribute to both, you may wonder what your best course of action is at this point. Here are two options to consider:

Build your TFSA now and boost your RRSP later. If you’re in the early stages of your career, for instance, you could focus on saving money in a TFSA, since your salary is lower than it will be in the future. Once you start earning a lot more, you can contribute the maximum allowable amount to your RRSP, where you’ll benefit more from the tax deduction by being in a higher tax bracket.

Use any tax refund to pay debt, boost savings. If you do contribute to an RRSP, think about using any tax refund you might receive to pay down debt or add to your TFSA — to spread the tax benefits into the future!

Plan ahead to reduce taxes

What’s most important is to plan ahead and have a strategy to reduce taxes and build resources throughout all stages of your career. Does investing in an RRSP, a TFSA, neither or both make the most sense for your household this year?

MD Financial Management can help determine the right strategy for you and your family to best achieve your financial goals. An MD Advisor can review your financial plan, or work with you to create one, and recommend ways to use your RRSP and/or TFSA contributions to minimize taxes and help you achieve your financial goals.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.

** Withholding taxes by foreign governments may still apply. For example, the Internal Revenue Service levies a withholding tax on dividends from U.S. companies held by Canadian resident investors.

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.