Investments

RRSP VS TFSA

The difference between RRSPs and TFSAs, which are two types of Canadian Registered Accounts for holding savings and investment assets, is a subject that is both simple and complex. The reality is that lots of important factors must be considered when it is time to decide which medium to use over the other depending on your individual circumstances.

In our case, we still have lots to learn in terms of strategies that are favorable for people who plan on leaving the employment world at a young age. The decisions we make in terms of the type of investments we choose as we build our portfolio to reach financial independence, will have a big impact on our strategy to withdraw funds from our investments in order to cover our expenses for the rest of our lives.

That is why I would like to keep this article a more simple introduction concerning these two investment vehicles. I will offer comparison of the functionality of each and identify advantages and disadvantages that could guide your choice in terms of which to prioritize over the other, and I will detail our approach.

 

RRSPs vs TFSAs

 

Comparing RRSPs and TFSAs

 RRSPsTFSAs
What they are?Registered Retirement Savings Plan (RRSP)

Created in 1957 to allow individuals to benefit from the same tax advantages available to members of registered employer-sponsored pension plans
The Tax-Free Savings Account (TFSA)

Introduced in 2009 following the economic crisis to encourage Canadians to increase their savings.
What they allow you to do?Invest a portion of your income before it is taxed.

The amount invested as well as all interest, dividend and gain generated will only be taxed when you will withdraw funds from the account.
Earn investment income which are not taxed.

All interest, capital gains and dividend earned in those account are not added to your taxable income even when those funds are withdrawn.
What are the advantages?Every contribution lowers your taxable income. The higher your revenue the higher the savings since you have a better chance at reducing your tax rate.

The theory is that you will have a lower tax rate once you are retired and need to withdraw funds from your RRSPs therefore they will be taxed at a lower marginal tax rate then they would have been when you initially invested those funds in your RRSPs.

Possibility to use those funds in order to purchase your first home under the Home Buyer’s Plan (HBP).
Once you withdraw funds, the contribution limit is not lost since the withdrawn amount will be added to the new contribution limit for the next year

For someone intending to retire at a young age that would choose to live on the income generated by their TFSA, it would be possible that their taxable income be very low, even 0$ depending on the total amount invested in their TFSA, its growth rate as well as the level of spending of the person. This could result in that person having access to various tax benefits to help finance his way of life.
What are the disadvantages?For an early retirement, the assumption that you will have a lower tax rate might be false, especially if you are planning to rely on money generated through investment vehicles that are taxable such as revenue generated with rental real estate.

Once the funds are withdrawn, the contribution space is lost.

At age 71, all RRSP needs to be completely withdrawn or converted into a Registered Retirement Income Fund (RRIF) and a minimum withdrawal amount must be made every year. This will have an impact on your capacity to receive different payments and tax advantages such as the Guaranteed Income Supplement (GIS) and the Old Age Security Pension (OAS pension).
Funds contributed to your TFSA do not reduce your taxable income and thus, are subject to income tax.

If you withdraw funds from your TFSAs during a fiscal year, although it will be possible to contribute those funds back the following year, it’s important to be careful not to contribute them during the same year as this could cause you to go over your contribution limit which would ensue a penalty tax of 1% per month for all excedentary contributions.
How to find out max amount you can contribute?You can locate your total maximum contribution limit on your notice of assessment or you can connect yourself directly on My Account of the CRA to have access to that amount as well as the calculation of the amounts for the past years for your RRSP limit since 1991.

Since 1990, every contributor is allowed to contribute up to 18% of their income earned in the previous year, without exceeding the limits prescribed in the Income Tax Act. Individuals that participate in a registered employer pension plan will see this contribution space be reduced by their pension adjustment which must obligatorily be indicated in your T4 or T4A statements (box 52).

In brief, the equation for the maximum contribution limit for the current year is=

(18% of the income earned in the previous year)
- (Pension Adjustment for the previous year )

To calculate your total cumulative maximum contribution limit, you add your maximum contribution limit amount for the current year to the maximum cumulative contribution limit of the previous year and you subtract any contributions that were made to your RRSPs in the previous year.
You can locate your total maximum contribution limit on My Account of the CRA, but keep in mind that financial institution can communicate information from the previous year as late as the end of March therefore it is important to keep track of the amounts you contribute or withdraw from your TFSAs every year in order to know what you may contribute as of January.

You start to accumulate TFSA contribution room at age 18. Contrarily to the RRSPs, the limits are not calculated from your income but are established by the government. The unused amounts are carried-forward.

The annual limits were:
2009 to 2012 = $5000
2013 & 2014 = $5500
2015 = $10000
2016 & 2017 = $5500
Therefore a person that has never contributed to their TFSA and that was 18 years of age in 2009 has a total cumulative limit of $52 000 in 2017.

A person who has contributed in the past and withdrawn funds, can use the following equation to determine their available contribution space for the current year (2017 for this example)=

(Total unused space on the first of January 2016)
- (Contributions made in 2016)
+ (Withdrawals made in 2016)
+ (Annual limit established by the CRA for 2017 =5 500$)

Our approach to RRSPs VS TFSAs:

At the start of our careers, we put our RRSPs to good use in order to buy our first property thanks to the Home Buyer’s Plan (HBP).

Indeed, an interesting aspect of RRSPs is the possibility to use those funds in order to purchase your first home under the HBP. The withdrawn funds at the moment of the purchase are not included in your taxable income and will then need to be repaid every year over a maximum 15 year period from the second year following the withdrawal of the funds. You would therefore need to plan to put 1/15 of the amount used under the HBP back into your RRSPs every year for those 15 years.

Then, we prioritized our TFSAs since we had the intention to use that money to eventually reimburse our remaining mortgage. By using our TFSAs, when we withdrew the funds, they were not added to our taxable income and the contribution space will be available for us to contribute in the future. We also incidentally increased the total contribution space in our TFSAs since the gains on the invested amounts created additional contribution space when we withdrew the total funds.

A second consideration, is that we knew that our salaries would eventually increase thanks to pre-established promotions or increases in our fields, therefore the contribution space that we weren’t using in our RRSPs would eventually be used to reduce our marginal tax rate.

Now that our mortgage is paid off, our strategy isn’t exactly defined in terms of prioritizing contributions in our RRSPs or in our TFSAs, at least until we can ideally maximize both, but for now that is not the case.

A few considerations that we need to evaluate in our situation:

  • We contribute to a registered pension plan offered by our employer. Our intention is to withdraw the calculated lump-sum value of our accumulated pension benefit once we decide to leave our jobs. That amount would then need to be transferred in part to a Locked in retirement account (LIRA) but another portion would be transferred directly to us and thus subject to income tax during that fiscal year. It could therefore be interesting to have extra space in our RRSPs in order to shelter a part of those funds and defer taxes on those to when we withdraw them from our RRSPs in future years.
  • However, if we take into account that our salaries will increase with future promotions in the next years of work, we know that we will likely have higher marginal tax rates. A higher taxable income might have negative impact on various tax benefits for example receiving lower amounts from the Canada Child Care Benefit (CCB), paying a higher additional contribution for subsidized daycares, etc. This might make it more beneficial to contribute to our RRSPs during our years of working full time, than it would be to use that contribution space to shelter the taxable portion of the amount we will be transferring from our employer’s pension plan.

That is why at the beginning of every year, we will prepare our tax returns as early as possible in order to take the time to evaluate what amount we should contribute to our RRSPs before the March 1st limit. We will have to become experts at identifying and knowing the tax rates as well as the rates which might affect various payments or tax benefits, thus the importance of knowing how to file and prepare your own tax returns.

We will also need to forecast the liquidity needed at the beginning of the year if we would decide to contribute up to the maximum contribution room available in our RRSPs. An interesting strategy, at least while contribution space remains in our TFSAs, would be to contribute during the year, in our TFSAs the amount we plan to put in our RRSPs at the beginning of the following year. This would help grow the space in our TFSAs with the gains generated from the deposited funds. We would then withdraw the initially invested amount from the TFSAs before December 31st in order to have the funds on hand to invest in the RRSPs before March 1st.

Conclusion:

In conclusion, the order or priority between contributing to TFSAs vs RRSPs will change depending on the situation of each person. Lots of factors should be considered when trying to decide between these two types of Canadian Registered Accounts: the age of the person when they plan to retire, the different circumstances allowing the person to reach certain tax benefits, the salary rates or the type of investments and tax rates on those investments and their returns, etc. In the future, I plan to examine various fictitious scenarios in order to try to identify the impact of how different circumstances affect the benefits of investing in RRSPs or in TFSAs.

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