One of the sure signs of tax season, as a financial advisor, are the questions about tax-sheltered investments.
How much should I invest in my RRSP?
Should I switch to a TFSA?
Which investment will give me the most tax breaks?
Everyone wants to know where to invest before they give the taxman his due. However, it’s rarely a simple answer. In fact, the answer always depends on each client’s financial situation.
So while we can’t give you a simple answer to the question ‘should I invest in an RRSP or a TFSA?’, we can walk you through the different reasons you may choose one over the other.
Let’s begin with defining the two terms: RRSP and TFSA.
What is an RRSP?
RRSP stands for Registered Retirement Savings Plan. It’s an investment vehicle designed to encourage Canadians to invest for their retirement by allowing investors to defer taxes. All Canadians can invest up to 18% of their income into an RRSP.
The first thing you have to understand about RRSPs is that they don’t allow you to skip out on taxes. At first glance, that doesn’t look that great. But, with good investing, you can save more and invest more.
Because funds invested into an RRSP are ‘pre-tax’, you pay no taxes on that money. So, if you’re in a 33% tax bracket and you invest $5,000, you’re investing $3,350 of your own money, plus $1,650 that would have been paid to the government in taxes. In effect, you’re earning interest on money that would have otherwise gone to the government.
Plus, if you’re making $50,000 a year, when you make that $5,000, you will only pay income tax on $45,000. Used prudently, this can help you move into a lower tax bracket, helping you to pay less in taxes while saving for retirement.
Keep in mind, however, that as soon as you pull any money out of your RRSP, you’ll pay income tax on it based on your income from the year you pull it out. That means, if you leave that $5,000 in until retirement, when you’re making less money, your taxes will be calculated on that lower-income.
That’s why it’s a better idea to stay away from this money until you’re retired and in a lower tax bracket.
What is a TFSA
TFSA stands for Tax-Free Savings Account. It’s designed to encourage Canadians to invest by sheltering all interest made in the investment account from taxes. The government allows you to invest $6,000 per year in a TFSA, with a lifetime budget of $75,500 in 2021 if you were 18 or over in 2009.
Unlike an RRSP, every dollar you invest in a TFSA is already taxed, so there’s no worry about getting taxed when you pull out any money. Instead of saving taxes on the front end, the TFSA shelters all earnings inside it meaning every penny your TFSA earns is free of any tax burden.
For example, if you invest $6,000 and receive a 5% return over ten years, you’ll earn about $3,700 which you won’t have to pay taxes on.
Is a TFSA or RRSP best for me?
Because both RRSPs and TFSAs have contribution limits, and both are helpful, it’s not always a question of either/or. Plenty of our clients invest in both TFSAs and RRSPs, maximizing the use of both.
However, for those who are not maxing out their RRSP or TFSA contributions, your choice of investment vehicle depends on your situation. Let's look at two main factors that will influence the best investment vehicle for you: Income and Intention.
One of the biggest deciding factors when it comes to choosing between an RRSP and a TFSA is your yearly income.
The general rule of thumb here is:
If you make under $50,000/year, invest your money in a TFSA
If you make over $50,000/year, invest your money in an RRSP
Let’s unpack this...
If you’re making under $50,000/year, you’re already in a lower tax bracket, so saving the tax now, only to pay it later probably won’t actually save you that much money. It will just defer the taxes. So, that blunts one of the main benefits of an RRSP.
However, if you’re making over $50,000/year, by investing in an RRSP you’ll save more in taxes than you’ll pay down the road – probably.
Let’s say you’re making $90,000/year currently and thus sitting at a 40% marginal tax rate. If you contribute $5,000/year to your RRSP, you’ll get a refund of $2,000, which you could use to invest – perhaps in a TFSA. When you retire, your income will most likely go down, leaving you in a lower tax bracket, at around 33%. That means when you pull out that $5,000, you’ll only have to pay $1,650 on it. So, over your life, you save $350 just on taxes.
While income is the biggest deciding factor when it comes to investments, it’s not the only criteria. Like we’ve covered above, it’s not always a case of either/or. If you earn over $50,000/year and contribute the full 18% of your income, but still intend on investing more, a TFSA will work well for you.
However, if you’re not hitting your maximum contributions, you should consider what you intend to do with your investment to help you decide whether an RRSP or TFSA is right for you.
This can include:
a) How long you wish to invest for
RRSPs are for long term investments, while TFSAs offer more flexibility.
RRSPs are designed almost (we’ll get to that later) exclusively for retirement. If you foresee yourself pulling money out of your RRSP down the road (especially down the road in your career when you may be making more money) you should invest your money in a TFSA. However, if you’re thinking of investing strictly for retirement, an RRSP will work better – especially as the tax payable on removal can act as a deterrent from early divestment, helping you save even more.
b) What you’re saving for
RRSPs are geared towards retirement, but offer options for education and buying a house, while TFSAs are flexible and can be used to save for anything.
RRSPs are a very specific savings vehicle, which makes them great for saving for retirement, and not much else. Except, (here’s where that almost comes in) there are options for using your RRSP to pay for education and for buying your first house. The Home Buyer’s Plan (HBP) And Lifelong Learning Plan (LLP) allow you to ‘borrow’ money from your RRSP to pay for your first house, or your education, tax-free. Bear in mind that this is considered a loan and must be paid back.
HBP allows you to borrow up to $35,000 to purchase a house, but must be paid back in 15 years
LLP allows you to borrow up to $20,000 over two years, but must be paid back in 10 years
If instead, you wish to save up for a down payment on a car, a months-long trip to Europe, or you simply want to keep your options open, a TFSA will work best for you.
c) Whether you can get a ‘matched plan’
If your employer offers to match any money you put into an RRSP, then investing in an RRSP is the best plan, regardless of income. Not only do you get to enjoy a tax benefit from your employer’s investment, but you receive extra money that will supercharge your savings.
Choosing the right investment for you
Investing can be difficult and confusing, especially for beginners. So, we’ll end this article with the most important investment tip of all:
No matter what investment vehicle you end up using, investing money is always preferable to not investing. Compounding interest rewards early investment, so don’t put it off, or allow confusion to stop you from investing.
There are a variety of resources available (like our blog), that can help guide you in terms of the best investments. We also encourage you to contact us for a friendly chat about investments – to help you get the most from your money.