Apart from being cold in Canada, February is RRSP season. Personal financial advisors and financial institutions blitz clients to make annual contributions to get a tax deduction from the previous year’s income. They tout RRSPs as the best tax deduction available, sometimes to students who pay little or no taxes, to boot! Let’s review Registered Retirement Savings Plans (RRSP) before commenting on the Tax Free Savings Plan (TFSA). The table below compares these two plans.
Registered Retirement Savings Plans (RRSP)
In 1957, as part of the Canadian Income Tax Act, the Canadian government created these registered programs, overseen by the Canada Revenue Agency (CRA), to encourage retirement savings. RRSPs have rules for annual contribution limits, contribution timing, fund withdrawals, and allowable investments.
RRSPs Two Principal Benefits
RRSPs have two primary tax advantages, but one is temporary. First, contributions reduce taxable income. For example, if your tax rate is 40%, every $100 you invest in an RRSP (up to the prescribed limit for the year) will reduce your taxes by $40. But at age 72, the rules require you to start annual withdrawal of funds from your RRSP (which morphs into a Registered Retirement Income Fund (RRIF) at age 71), and pay taxes on withdrawals. If your tax rate then is 40%, every $100 removed would increase your taxable income, and you pay $40 taxes. That’s why I refer to this as a temporary benefit. It’s best to view this tax deduction as a tax deferral. Still, it could be beneficial because when you withdraw funds from your RRIF, your tax rate might be lower than the initial 40%.
The second and most significant benefit is tax sheltering of growing funds in the RRSP account: savings and investment gains in an RRSP attract no taxes, unlike non-RRSP accounts. Accumulated capital gains, dividends, and other increases pay no income tax—your investments in your RRSP account compound tax free until withdrawn. When you withdraw funds, even if all your gains were capital gains, funds taken in any form (cash or investments) attract taxes at your marginal or highest tax rate:
Effect of RRSP Investment & Withdraw at 71
- Assume you invested $50,000 in your RRSP over several years and lowered your taxes by $20,000 (40% tax rate).
- By clever investing, $50,000 grew to $500,000 at age 71.
- At age 72, you must start withdrawing amounts each year, based on the government’s prescription.
- For someone age 72 in 2021, the current withdrawal rate is 5.5% which rises yearly to 20% at age 90. Thus, you would pay taxes on 5.5% of $500,000 or $27,500 in 2021. At 40% tax rate, your taxes would be $11,000.
Think of your RRSP as containing two streams, both earning income: your net cost and the tax refund from the government.
You may contribute to a spousal RRSP provided you have contribution room. If you have unused contributions from prior years of $20,000, you may contribute this amount to a spousal RRSP. The benefit arises if your income is higher than your spouse’s, and you expect it to remain higher. The RRSP becomes your spouse’s. She or he will withdraw funds in the future at a lower tax rate than yours. If you choose to use this benefit, get to know the rules.
CRA prescribed RRSP contribution limit for 2021 at 18% of an individual’s income on his or her 2020 tax return to a maximum of $27,830. Persons who have not been contributing their maximum over the years may add this unused contribution to the year’s prescribed limit. Contributions of $2,000 above your annual limit will attract a penalty.
You may withdraw cash or investments from your RRSP any time but you must include those amounts as taxable income in the withdrawal year. Subject to conditions, if you use those funds to buy or build a home or for education, you pay no taxes then. But you must repay these amount according to a prescribed schedule. Avoid these withdrawals as the TFSA (discussed below) is the preferred option to save for a downpayment on a home, and to replace The Lifelong Learning Plan (LLP).
Registered Retirement Income Funds (RRIFs)
CRA mandates RRSP withdrawal rules. The year the RRSP holder turns 71, he or she may liquidate the balance and pay taxes on the withdrawn amount. But the usual alternative is to transfer the account to a Registered Retirement Income Fund (RRIF) seamlessly, or to an annuity. Required withdrawals begin the next year.
RRSP versus 401 (k)
RRSPs and 401(k)s are similar but have a few differences:
- Employers set 401(k)s, but individuals establish RRSPs
- Individuals may carry forward RRSP unused contributions. This does not apply to 401 (k)s
- Employers may deduct employees’ RRSP contributions from payroll, or employees may make cash contributions, but for a 401 (k), payroll deductions fund the account
- With a few exceptions, 401 (k)s have early withdrawal penalties, but RRSPs do not
Tax Free Savings Account (TFSA)
The TFSA is an excellent savings vehicle introduced by government at the height of the Great Recession in 2009. In this account, your contributions, interest, dividends and capital gains grow tax-free. When you invest in a TFSA, you contribute after-tax dollars, which means you paid income tax already. Thus, when you withdraw funds, you pay no taxes.
Taking the RRSP example above: You invested $50,000 in your TFSA, which is after tax:
- You would have earned $83,333
- Paid 40% of $83,333, or $33,333 taxes
- Take home $50,000 to invest.
Like an RRSP, a TFSA is a vehicle that can hold cash in a savings account, stocks, bonds, and other securities. To open a TFSA, you must be 18 or 19 years old – depends on the age of majority in your province – a resident of Canada, and have a valid social insurance number (SIN). If you live in a province where 19 is the majority age, you can accumulate TFSA room starting at age 18. TFSA’s annual contribution limit for 2021 is $6,000 plus contribution room and withdrawals from previous years. Assume you started contributing in 2009 and contributed $50,000 by the end of 2020 after withdrawing $20,000 total in 2019 and 2020. How much can you contribute in 2021?
- Maximum TFSA contribution allowed from 2009 to 2021= $75,500
- Your contribution to date = $50,000
- Contribution room = $75,000-$50,000 = $25,500 + Withdrawal $20,000
- 2021 contribution maximum is $45,500 ($25,500 + $20,000)
If your TFSA is your savings account, don’t invest in stocks or bonds as these are long term investments. Use money market or other savings instruments that protect your principal and are available at short notice without reduction. Note that some TFSA providers charge for withdrawals and transfers, so become informed before opening your accounts.
Which is better, RRSP or TFSA? It depends on your situation. Review your goals. Consider your RRSP for your retirement only; don’t “borrow” from it. Your TFSA is for targeted savings: downpayment for a home, an engagement and wedding ring, a car and other big ticket items. Unless your employer provides a benefit if you contribute to an RRSP, save in a TFSA until you are ready to save for retirement. But always look at your goals, and your life situation before deciding.
Still, before saving and investing in an RRSP or TFSA, research, understand differences between savings, investing, gambling, speculating, and develop goals, plans, and a budget:
- Save = no risk to your contribution
- Invest = some risk
- Gamble = taking a chance with great risk
- Speculate = similar to gamble
From whom you get information and advice about TFSA and RRSPs is important. Unless working in a firm of independents, financial advisors do not provide independent advice. Typically, they represent financial companies and sell only those companies’ products; they are sales people. Some financial advisors will tell you to borrow to contribute to your RRSP because you can repay the loan with the tax refund. Don’t borrow to invest. If you need to borrow, you will not have funds to repay the loan. Moreover, your tax refund will be less than your RRSP contribution.
While this is not a comment on individual financial advisors, reality is they are in a conflict of interest—advising you while selling you products. Get to know financial companies they represent and those they exclude, before buying their products. Consider these other factors in your decision making:
- If you pay no taxes, you get no immediate benefits from an RRSP. You should question whether you might get a long term benefit.
- Despite pressures from media and salespeople, do not look at your RRSP decision by itself. And do not make your RRSP, or any decisions, solely on the tax benefit. Look at the bigger picture, the opportunity cost (what you will forego to invest), and count the cost of that decision.
- Start implementing a plan to become debt free before planning your retirement, including RRSP contributions.
- You may ask: should I repay my mortgage before starting an RRSP? Repay all interest bearing debts first, even with today’s extra low interest rates. Strive to be debt free. Repaying your loans will produce a definite “savings” of interest expenses.
- If your employer provides a benefit when you invest in an RRSP, take advantage of it after reviewing your overall situation.
- The TFSA is an excellent savings vehicle. Use it as targeted savings, but do not invest the funds in stocks or bonds if you intend to use those funds within one year; place them in a savings-type account like the money market.
- Keep in mind that your contribution to an RRSP creates a tax deferral only; you will pay taxes later.
© 2021 Michel A Bell
Rising Interest Rates Will Harm You Only If You Gamble With Your Future