Many Canadians ponder whether they should contribute to their Tax-Free Savings Account (TFSA) or their Registered Retirement Savings Account (RRSP). You might ask yourself, which account should I contribute to first? Well, there isn’t always a clear answer to this question – it often depends on your personal financial situation and your future financial goals and needs.
Let’s start with a brief overview of how both accounts work.
An Overview of TFSAs
- Contributions to your TFSA are made using after-tax dollars and do not reduce your taxable income in the year you contribute, as there is no deduction allowed for TFSA contributions.
- Income earned on investments held within an TFSA are not taxed when earned.
- Both the income earned on investments and the original contributions made to your TFSA are not taxed when they are withdrawn from the account. This means income earned on TFSA contributions is permanently sheltered from tax.
- Unused contribution room is not lost but carried forward until used. There is no age limit to contribute to a TFSA.
An Overview of RRSPs
- Contributions to your RRSP are made using pre-tax dollars – they may reduce your taxable income in the year you contribute as you can take a deduction for RRSP contributions made.
- Income earned on investments held within an RRSP are not tax when earned.
- Both the income earned, and the original contributions made to your RRSP are taxed in the year they are withdrawn from the account.
- Unused contribution room is not lost but carried forward each year until it is either used or the taxpayer turns 71 and can no longer contribute.
Which account best suits my personal situation?
Now, lets look at some considerations that might help you determine which account best suits your personal situation.
What is your current marginal tax bracket?
Given that RRSP contributions reduce your taxable income, it can be more advantageous to make contributions when you’re in a higher tax bracket because the tax deferral is greater.
For example, if we are only looking at the Federal Tax rates, an individual in the lowest marginal tax bracket who made an RRSP contribution would create a tax deferral of 15% on the amount contributed, however an individual at the highest marginal tax bracket would create a tax deferral of 33% on the amount contributed.
What is your career’s earning potential?
As noted above, there can be an advantage to deferring RRSP contributions until you’re in a higher tax bracket. If you’ve already reached your maximum approximate earning potential however, this consideration no longer becomes as relevant in your considerations.
Also, it’s important to consider the time value of money – while you may not be at the peak of your earning potential now, if that time is far away, it may make sense to take the deduction now. You can then use any resulting tax refund to contribute additional funds, and start earning income on a tax-deferred basis on even more money.
When do you anticipate needing the contributions and the earned income?
If you’re saving for something you plan on purchasing in a relatively short timeframe, a TFSA might be a better avenue. This is because both the original contributions and the income earned can be withdrawn on a tax-free basis.
Withdrawals from an RRSP, aside from those under specific programs, attract withholding tax.
What is your risk tolerance and the types of investments you plan on purchasing?
If you have a higher risk tolerance and are looking to purchase more speculative investments that have larger potential upsides, they may be better suited to a TFSA because the increase in value would be tax free when realized. On the flip side, if your risk tolerance is lower, and you’re focused on more secure blue-chip investments, an RRSP could be the better option.
The First Home Savings Account (FHSA)
An additional account to consider is the First Home Savings Account (FHSA). The FHSA is a new vehicle for first-time home buyers and it has attributes of both the RRSP and TFSA. Like an RRSP, contributions are tax-deductible, allowing contributions to be deducted to reduce your taxable income. Like a TFSA, withdrawals of contributions and income earned thereon are not taxable.
With an annual contribution limit of $8,000, the FSHA is anticipated to be available late spring 2023.
At the end of the day, TFSAs and RRSPs have their own unique benefits and a mix of both is often a good approach. However, depending on your current financial position and your goals moving forward, you may be better suited to one over the other.
If you have any questions regarding any of the information above or are looking for help determining which account might be a better option for you, Armstrong Jones LLP is here to help. Feel free to contact us online or call us at 613-695-9087.
