Have you heard of registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs) but aren’t sure what the difference is? Are you trying to figure out which is best for you and your financial security plan?
I can help – let’s take a closer look.
Before you decide whether to contribute to an RRSP or a TFSA, you’ll want to consider your goals and your current and future tax rate.
One main consideration is what your marginal income tax rate is now versus what you expect it to be when you plan to make a withdrawal. Here are two scenarios to consider:
Your tax rate is expected to be lower when you’re withdrawing money than it was when you were contributing money.
Your initial contribution (40% tax rate)
Grows to $1,592 $2,653
Your withdrawal in 20 years (30% tax rate)
After tax $1,592 $1,857
Recommendation: RRSP first, then TFSA
Your tax rate is expected to be higher when you’re withdrawing money than it was when you were contributing money.
Your initial contribution (30% tax bracket)
Grows to $1857 $2,653
Your withdrawal in 20 years (40% tax rate)
After tax $1,857 $1,592
Recommendation: TFSA first, then RRSP
Ultimately, one isn’t better than the other. There can be a place for both an RRSP and a TFSA in your financial plan.
An RRSP can be more beneficial if you’re currently earning a high income because it helps you defer taxes until later in life when you may have a lower tax rate and pay less tax overall.
On the other hand, your TFSA can be more tax-effective if you expect your tax rate to be higher when you withdraw money than it is when you contribute money. This makes a TFSA suitable if you’re in a lower income bracket but expect to be in a higher tax bracket later.
An advisor and investment representative can help you decide whether it’s more beneficial to pay taxes on your income now or in the future, based on your unique situation.
Assumptions: $1,000 pre-tax income in an RRSP, an equivalent after-tax amount contributed to a TFSA based on 30 and 40 per cent tax rates. Growth assumes a five per cent annual rate of return for 20 years.
Karen McNamara, QAFP, CHS
Financial Security Advisor, Freedom 55 Financial
The information provided is based on current laws, regulations and other rules applicable to Canadian residents. It is accurate to the best of our knowledge as of the date of publication. Rules and their interpretation may change, affecting the accuracy of the information. The information provided is general in nature and should not be relied upon as a substitute for advice in any specific situation. For specific situations, advice should be obtained from the appropriate legal, accounting, tax or other professional advisors.