Best Option-RRSP orTFSA?

What is the Best Option: RRSP or TFSA?

January 2017

Wednesday March 1, 2017 is the last day to contribute toyour RRSP and use the tax deduction on your 2016 taxes. Every year as the deadline nears the debate resurfaces: what is better adding to a RRSP or a TFSA? You’d probably love to maximize both accounts, however for most folks that’s not an option. So what is the best option?

A quick overview of the accounts: you receive an immediate tax deduction for any RRSP contribution, however all withdrawals are fully taxable. The RRSP contribution limit is based on your earned income. It is 18%of your earned income up to a maximum of $25,370. Although the TFSA does not provide the immediate tax savings of a RRSP, it is far more flexible and you can withdraw the funds at any time without tax consequence. The TFSA started in2009. The contribution limit has changed a few times over the years, in 2017 you can add $5,500 to your TFSA. If you do not contribute the maximum in a year your contribution carries forward. The total contribution room since 2009 is $52,000.

There are pros and cons to both accounts. By far the biggest positive for both the TFSA and the RRSP is that they benefit from tax sheltered investment growth. Even a modest growth rate when compounded tax free can produce significant gains over time.

An additional positive of contributing to a RRSP is that you receive an immediate tax deduction. In my opinion, the tax deduction is best viewed as a deferral of tax. You save the tax today but you will have to pay tax down the road when you withdraw the money.  A RRSP contribution often makes sense if you are in a high tax bracket. Especially if you are in a high tax bracket when you contribute to a RRSP and a low tax bracket when you withdraw the funds. The difference in tax rates works in your favour; the larger the difference in tax rates the bigger the benefit. The reverse is also true. If you are in a lower tax bracket when you contribute to a RRSP and a higher tax bracket when you withdraw the money, contributing to a RRSP does not make sense, the TFSA would be the best option. The trouble is that it can be difficult to forecast our future tax rate.

As well changes in assets can create temporary spikes inincome. For example the sale of a cottage, the sale of land or receiving a severance package from work are all common occurrences that create a bump in your tax burden. If you have a large tax burden in a particular year a RRSP contribution makes sense, it can significantly lower your tax bill.

As a general rule when there is a temporary bump in your income or if you are in a high tax bracket when you contribute and you expect to be in a low tax bracket when you withdraw the money, a RRSP contribution makes sense. However, if your tax rate at the time of contribution is lower or the same as your expected tax rate at withdrawal,it would make more sense to use the TFSA.

A note from experience, I work with a number of retirees and in most cases folks maintain their pre-retirement lifestyle in retirement. Often that means they are in a similar tax bracket in retirement, reducing the benefit of the RRSP. In an ideal world you would maximize both accounts, however, if an individual only has enough funds to contribute to one account I often suggest the TFSA.

Clinton Orr B.Comm(hons.), CIM, CFP, DMS, FMA  lives in Beausejour and is a portfolio manager with National Bank Financial.

 

 

This information transmitted is intended to provide general guidance on matters of interest for the personal use of the reader who accepts full responsibility for its use, and is not to be considered a definitive analysis of the law and factual situation of any particular individual or entity.  As such, it should not be used as a substitute for consultation with a professional accounting, tax, legal or other professional advisor. This commentary reflects my opinions alone, and may not reflect the views of National Bank Financial Group.