I have lots of contribution room in my TFSA and RRSP, which should I focus on?
Both tax free savings accounts (TFSAs) and registered retirement savings plans (RRSPs) can be good places to invest money for the future. These two types of accounts are useful in different ways and so when it’s more beneficial to use one over the other varies.
Let’s talk about TFSAs first. With a tax free savings account, you don’t get any immediate benefit from money you put into the account, but you also don’t pay any tax penalty for taking money out of the account. It’s neutral in terms of deposits and withdrawals. What makes a TFSA special is that the owner doesn’t pay any taxes on money the TFSA makes.
With most types of investments, money you make off the investment is taxed. It’s treated like a type of income. With a TFSA any money your investment makes is not taxed. This means you can put funds into your TFSA and later withdraw the original amount plus money your investment earned, and the extra funds won’t be taxed. If you invest $10,000 in a TFSA and withdraw $14,000, none of the $14,000 is taxed.
This makes TFSA a good option in a few scenarios:
- Your income is relatively low now compared to what you are likely to make later. In other words you don’t need an income tax credit for investing money.
- You plan to withdraw money from your investments before you retire. In other words you’ll likely withdraw the money while still earning income elsewhere. A TFSA avoids paying taxes on withdraws.
- You are not sure when you might need to withdraw the money.
- You suspect your investment will grow quickly and wish to avoid being taxed on the growth in your investment account.
Next, let’s look at an RRSP. When you put money into an RRSP you gain tax credits which save you money when you file your income tax return. Any money you put into an RRSP effectively reduces the amount of income you’re viewed as having. In other words, if I earned $100,000 last year and I put $15,000 into an RRSP, then I’m taxed as if I made $85,000. This will probably save me around $5,000 to $7,000 when I file my income tax return, depending on where I live.
Saving money at tax time is nice, but the flip side to an RRSP is any money withdrawn from the RRSP is taxed as if it were income. The RRSP basically acts as a source of income when we withdraw from it.
Because the key benefit of an RRSP is deferring income tax, people usually put money into their RRSP when their income is relatively high. It’s a much bigger benefit to deposit money into your RRSP if you make $200,000 (and are probably taxed around 40%) compared to if you make $30,000 and likely pay under 25% of your income to taxes.
Money is usually withdrawn from an RRSP after retirement when a person’s income is close to $0. This allows a person to withdraw money from their RRSP at a lower income level (and lower tax bracket) than when they put the money in.
In other words, it’s a good idea to use an RRSP when:
- Your income is relatively high.
- You know you won’t need the money being invested until you retire.
In short, if you are making a high wage now and you don’t plan to use the money you’re saving until retirement, consider using your RRSP contribution room. If your income is relatively low now (and likely to rise later) or you may need the money you’re investing before you retire, look at using your TFSA.
Comments are closed, but trackbacks and pingbacks are open.