February 29th is the final day to make a contribution to your Registered Retirement Savings Plan (RRSP). Like most Canadians you probably scramble at the last minute to find some extra cash, or even consider taking out an RRSP loan. You probably don’t even give much consideration to your overall investment plan – other than the nice tax refund! But do you really need to contribute to Your RRSP? Would the TFSA be a better option? Let’s look at the pros and cons of each plan before you rush to your bank for a RRSP Loan.
Not only can you contribute to your RRSP, but you can also take advantage of the Tax Free Savings Account (TFSA) introduced by the government in 2009. Many Canadians are still unfamiliar with the TFSA and how it works, continuing to contribute to their RRSP. Both plans shelter your income tax-free, both plans have benefits, and both the TFSA and RRSP work in different ways. The biggest difference is the treatment of taxes in each plan. Let’s look at the basics!
The RRSP (Registered Retirement Savings Plan) is what most Canadians are familiar with. This is a powerful investment and savings tool, which provides tax-free compounding growth, in addition to lowering your taxes. When you contribute to your RRSP, the contribution is deducted from your income. For most people this usually results in a tax refund. The higher your income the higher your refund! Sounds like a winning plan, doesn’t it?
However, a RRSP contribution is nothing more than a tax-deferral plan and this is the way you really need to view it. The string attached most people forget, is that you get taxed when you make withdrawals from your RRSP. That’s because RRSP withdrawals become taxable income. So the tax man cometh back for the refund he gave you! There’s no way around this – it’s about as absolute as gravity.
RRSP withdrawals become taxable income.
Think of the tax refund from your RRSP contribution, as a loan from the government that you have to pay back. So when you make contributions to your RRSP think for the long term. Where will you be when you retire – will your income be higher or lower? Does an RRSP contribution really help you lower your taxes? Can you use the refund for investing or to help pay down your mortgage or consumer debts?
Here are the RRSP basics:
- A RRSP is not an investment. It is a registered plan for sheltering taxable income.
- A RRSP is not just for savings, you can hold mutual funds, stocks, or bonds in a RRSP.
- You can contribute a higher amount to an RRSP than a TFSA (see your tax assessment).
- You can carry forward any unused contributions.
- You get a tax deduction for contributing. For most Canadians this results in a tax refund.
- You pay taxes when you withdraw money from an RRSP.
- You cannot use your RRSP investments as collateral for a loan.
- You cannot write off the interest for an RRSP loan.
- You cannot hold your RRSP after age 71. It must be converted into a RRIF, an Annuity, or even worse withdrawn and declared as taxable income. That’s a bad thing!
Many people haven’t utilized the full benefit of the TFSA (Tax Free Savings Account), which in many ways is a much better deal than the RRSP. The bottom line is, when you contribute to a TFSA you do not get a tax-deduction or a refund. But you can withdraw money from the TFSA tax free! This makes the TFSA an ideal investment plan to save for retirement. You can save tax-free, withdraw tax-free, and reduce the amount of taxes you pay at retirement. It won’t affect your government benefits in retirement, which income from your RRSP can. The only catch is that you are limited to $5K per year, and any withdrawals reduce your current annual contribution room. However you can contribute that amount back in the following year.
Here are the basics:
- The TFSA is not an investment. It is a registered plan for sheltering taxable income.
- A TFSA is not just for savings, you can hold mutual funds, stocks, or bonds in a TFSA.
- For 2012 your maximum contribution room is $20,000 (4 years x $5000 per year)
- You can carry forward any unused contributions.
- You do NOT get a tax deduction for contributing.
- You do NOT pay taxes when you withdraw money from a TFSA.
- You can use your TFSA investments as collateral for a loan or line of credit.
- You cannot write off the interest for a TFSA loan.
- There are NO age restrictions on the plan – you can hold it until your 99 (or 103 if you want)
Which One is Right for you?
For some Canadians the $5K per year limit on the TFSA is a drop in the bucket, and for most Canadians finding an extra 5K per year is virtually If you find yourself under the 50K to 60K salary mark, and have to choose one or the other, consider the TFSA over the RRSP. You won’t get that nice refund every year. But when you withdraw money from your TFSA, you won’t be paying any taxes either. You won’t owe the government anything! How sweet is that?
Maximize The TFSA, and Forget The RRSP.
If you’re a higher income earner, you will benefit from RRSP contributions because the refund amount will be higher, as you are in a higher tax bracket. That leaves you two options. First, you can maximize your RRSP contributions and get the largest refund possible. That refund then can be reinvested again into the RRSP, a TFSA, or even used to pay down the mortgage.
The second option is to optimize your RRSP. This means you only contribute to your RRSP what is necessary to reduce any taxes payable. You then maximize your TFSA contributions. Anything left over then goes into your RRSP.