In our last column we outlined the “facts” on the highly advertised Tax Free Savings Account (TFSA) that are now widely available.
So now the question during this time of year might be, should I contribute to my RRSP or the new TFSA?
Ideally RRSP’s are savings vehicles designed to contribute to when you are in a higher tax bracket than when you want to withdraw them. RRSP’s of course allow you a tax deduction when you contribute to them and tax deferral on growth that you have within the plan. What that means is you do not have to pay taxes on any interest, dividends or capital gains that are generated on those investments as they grow within the plan. Similar to the TFSA. You can generate a higher rate of return within an RRSP when the effective tax rate at withdrawal is lower than the effective tax rate at time of the contribution.
For example, if you contribute $1000 to an RRSP when you are in a 20% tax bracket, your net cost after savings is $800. If you are in the same bracket when you make the withdrawal of $1000, your net withdrawal will be equal to your net cost after paying taxes ($800). However if you are in a 40% tax bracket when you make your withdrawal, then your net withdrawal will be $600.
Possible Strategies….
A TFSA can be an ideal savings vehicle if you are in a lower income tax bracket. RRSP’s may not always be well suited to low income Canadians. The RRSP tax savings may be insignificant for you now, and you may be in a higher tax bracket when you make withdrawals. Also keep in mind that TFSA withdrawals do not impact income tested benefits and credits such as child tax credits, Old Age Security (OAS) and the Guaranteed Income Supplement (GIS).
If you currently find yourself in a middle income bracket, with expectations of being in a higher one down the road, you could save in a TFSA now and contribute to RRSP when you are in the higher bracket.
High income individuals may want to maximize both your RRSP and TFSA contributions. In fact tax savings or a refund generated from an RRSP contribution could be used to fund the TFSA.
Another point that I find has not been well explained about TFSA’s is they DON’T have to only be invested in traditional savings accounts. In fact you can hold stocks, bonds, mutual funds within provided you have opened the appropriate kind of account. This is a topic itself for another column.
There are many strategies that can be implemented depending on your individual situation and goals. The TFSA is a wonderful vehicle that can be great addition to your overall financial planning strategies, and as always review these with your financial advisor to find the ones that are best suited to you.
