Using RRSPs and TFSAs to Grow Your Wealth

Many Canadians are uncertain about how best to use an RRSP and a TFSA to save for the future.

RRSP accounts have been around since 1957 when pensions were the main form of retirement savings for working Canadians. Not everyone was able to contribute to a pension so the RRSP was introduced to level the playing field. Since then, the federal government has added new features to the RRSP that allow Canadians to use funds for a first-time home purchase (HBP), pay for education (LLP), or income-split with a spouse (Spousal RRSP).

The TFSA was introduced in 2009 to encourage Canadians to save even more.

With RRSP season upon us, now is a good time to address the question, “which account is better?”

RRSP vs. TFSA

Many advisors are polarized in their belief of which registered account is best, often because of a bias or assumptions made without proper planning. Rather, both have unique advantages and disadvantages and both should be fully utilized where possible.

The decision to utilize either or both of these savings vehicles depends on one’s personal financial circumstances and savings goals. The most important factor to consider is marginal tax rates at the time money is contributed versus when it is withdrawn. Mathematically, the two accounts provide the exact same after-tax benefit if you have the same marginal tax rate at all times. The RRSP is most efficient when contributions are made in high tax-rate years and withdrawn in low tax-rate years. The TFSA works best the other way around; making contributions in low tax-rate years and withdrawing in high tax-rate years.

The savings goal becomes a factor when determining how and when the money will be used. For example, an RRSP may provide a greater tax benefit for retirement savings since marginal tax rates are generally lower during retirement compared to working years. If saving for a down payment on a house, an RRSP may make sense since withdrawals of up to $35,000 can be made without tax consequence and pre-tax dollars can be put towards the down-payment instead of after-tax dollars. If saving for an emergency fund or supplemental retirement income, a TFSA may be preferable due to its flexibility to withdraw dollars when needed without increasing taxable income or affecting income-tested benefits such as OAS.

PROS AND CONS

Tax sheltering is by far the biggest advantage to both of these accounts. Investment income is either tax-deferred or tax-free, which essentially keeps those unpaid tax dollars in the account. This enables compounding at a faster rate, compared to a non-registered account. Over the long term, the net benefit with compounding can be substantial. Further, investors with both registered and non-registered investments may achieve greater tax efficiency by placing investments with high income/interest in registered accounts and growth/capital gains and dividends in non-registered accounts.

Aside from tax-sheltering of investment income, RRSPs and TFSAs have the added benefit of naming any number of beneficiaries so the value of the account will pass directly to those beneficiaries outside of the estate/probate process. If survived by a spouse or common-law partner, this person can receive the RRSP without tax consequence (a roll-over) or the TFSA (as a successor-holder) and continue to take advantage of the tax-sheltering nature of these accounts.

Of course, you can’t have your cake and eat it too. One of the biggest drawbacks of the RRSP account is that the entire value of the account becomes taxable income in the year of death if the beneficiary is anyone other than a spouse or common-law partner or financially dependent child/grandchild with a disability. The effect of this can be a push into a higher marginal tax bracket and defeat the purpose of deferring withdrawals until lower tax-rate years. In addition, the tax liability is payable by the deceased’s estate and not from the proceeds of the RRSP. This is an important factor to consider in tax and estate planning, in cases where the deceased has named an RRSP beneficiary (such as a sibling) and minimal estate value available to pay the taxes owing.

HOW RRSPs WORK

An RRSP is a tax-deferred savings account for Canadians with earned income, which means the account consists entirely of pre-tax income. Tax is payable only when withdrawals are made from the account. Things can easily get complicated with deduction limits, contribution limits, not to mention pension adjustments.

Contributions

Contribution room is an ongoing source of confusion. Each year, contribution room is earned that is equal to 18% of prior-year earned income or the maximum limit, whichever is less. The maximum limit for 2020 is $27,230. The contribution room earned is reduced if pension plan contributions are made. Contribution room accumulates each year if unused. Therefore, at any point in time, the RRSP contribution limit is equal to the accumulated contribution room. Consulting the prior-year Notice of Assessment from CRA is the first step in figuring out the contribution limit for the current tax year. For example, if accumulated contribution room equals $118,000 on the 2018 Notice of Assessment, then a deposit of up to $118,000 can be made into an RRSP without penalty.

Deductions

The most common misconception that we encounter about RRSPs is that the entire contribution must be deducted on the tax return. In fact, it might not make sense to deduct all of the RRSP contribution in the current tax year. The truth is, one can choose to deduct all, a portion, or even none of the amount contributed. This feature of deferring the RRSP deduction is an underappreciated benefit of RRSPs that allows one to take advantage of the tax-sheltering nature of the RRSP as soon as possible while waiting for the optimal time to use the deduction. To illustrate, in the example above, let’s assume that a contribution of $118,000 is made this year. Tax planning reveals that income and marginal tax rates will be much higher next year. After some analysis, the optimal deduction is found to be $28,000 this year and $90,000 next year. After filing the 2019 tax return, the Notice of Assessment will show contributions of $118,000 minus deductions of $28,000, which equals $90,000 of undeducted contributions available to deduct in future years.

This feature of the RRSP also works the other way around. If RRSP contributions remain undeducted at age 71, the year an RRSP is required to be converted to a RRIF or used to purchase an annuity, these funds can be withdrawn without tax consequence

Withdrawals

RRSP funds can be withdrawn at any time. The amount of the withdrawal will be treated as taxable income in the year of withdrawal and standard withholding taxes of up to 30% will apply.

There are exceptions when funds are withdrawn for a first-time home purchase (HBP) or to pay for continuing education (LLP). In these cases, a special form is used to process the withdrawal without any withholding tax. Funds withdrawn for a HBP or LLP must be re-deposited over the next 15 and 10 years, respectively, to avoid any tax consequences.

When funds are withdrawn from an RRSP, there is another downside that is frequently overlooked. Contribution room that was earned and used to deposit money into the RRSP is lost forever. Money withdrawn will no longer benefit from future tax-sheltering. This is arguably the bigger reason to avoid RRSP withdrawals, instead of the income tax consequence.

The tax-sheltering benefit of the RRSP is not indefinite. Under existing rules, an RRSP is required to be converted to a RRIF or used to purchase an annuity by the end of the year in which the annuitant turns 71. Starting the following year, a minimum amount is required to be withdrawn each year as taxable income and funds can no longer be deposited to the account. Fortunately, RRIF withdrawals are considered eligible pension income for tax purposes, as long as the annuitant is 65 or older.

HOW TFSAs WORK

The TFSA is described as a tax-free savings account because investment income earned within the account is tax-free. Unlike RRSPs, contributions are made with after-tax dollars.

Contributions

Contribution room is not tied to earned income. At age 18 and each year thereafter, one receives the maximum annual limit. The maximum limit for 2020 is $6,000. Contribution room accumulates each year and there is no annual contribution deadline.

Withdrawals

Withdrawals from a TFSA can be made at any time without any tax consequences or penalties.

Unlike RRSP withdrawals, TFSA funds can be re-deposited the following year or later. At any point in time, an individual’s TFSA contribution limit is equal to the contribution room calculated on January 1st of the calendar year. The limit accounts for all prior-year contributions and withdrawals. Thus, if short-term funds are needed from a TFSA with the intent of re-deposit, greater tax efficiency is achieved if the withdrawal is done in December rather than January.

The most common misconception we encounter about TFSAs is that it is an ideal account for short term cash investments. However, given the tax-free status, investments with higher long-term growth potential are typically better suited for a TFSA.

HAVE A QUESTION?

Do you have any questions or would like to see any other financial topics addressed on our website? Email me your suggestions at mtatham@generationpmca.com.