Canadians say they are worse off today than a year ago at rates never seen: Shachi Kurl
The sky-high cost of living means Canadians are having to spend more of their income on basic life necessities, leaving less money left over at the end of the month for discretionary spending and future savings.
This was demonstrated in a recent Angus Reid survey, which showed 19 per cent of respondents had deferred or outright halted contributions to their Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) in the face of surging inflation.
For an individual that might only have enough funds to contribute to one account or the other, one of the main difference between an RRSP and TFSA comes down to their tax implications, since both accounts can hold the same types of investments.
“If tax becomes the differentiator, and that's what the decision has to be based on -- a tax methodology, not an investment methodology -- then it comes down to marginal tax rate. What is your marginal tax rate today versus what you expect your marginal tax rate to be in the future?” said Tony Salgado, president and founder of AMS Wealth, in a phone interview.
He said those with a low marginal tax rate are likely better off putting the money into a TFSA since the immediate tax savings from an RRSP would be minimal.
Money that’s contributed to an RRSP is tax deductible, and when the money is withdrawn, it’s subject to income tax. On the contrary, contributions to a TFSA are not tax deductible, and in turn, the money, and any investment income, are not taxed when withdrawn from a TFSA.
Jessica Moorhouse, a financial counsellor and the host of the More Money Podcast, said the first thing investors should consider when deciding which account to utilize is if the money is intended for retirement or a shorter-term goal.
“TFSAs are great for more short-term saving/investing goals since you have the flexibility of pulling that money out of the account tax-free (since you contributed after-tax dollars into the account). So you won't be penalized for taking money out, like you would be with an early RRSP withdrawal which would be subject to withholding tax,” she said via email.
“RRSPs really were built for long-term investing for your retirement, although they could also be utilized for the First-Time Homebuyer Plan or Lifelong Learning Plan if necessary (though in general, they should be used simply for future retirement saving).”
With uncertainty in the economy and the high cost of living, Frank Gasper, the founder of CSR Wealth Management, said he typically favours the TFSA since it has more flexibility in terms of withdrawals, providing the client with better control over their cash flow, and because investments are allowed to grow tax free.
To take advantage of both accounts though, he said one strategy is to put the funds into a TFSA where the money can grow. Then as the March 1 RRSP contribution deadline approaches, the individual can withdraw the money from the TFSA and stash it in their RRSP to get the tax refund.
The strategy allows the client to reap the benefit of tax-free growth in the TFSA while still having easy access to the money and then take advantage of the tax refund stemming from the RRSP contribution.
“If the concern is I might need this money, or this is this is extra money and I'm never going to need it till retirement, it's still not going to hurt to throw it in the TFSA first,” Gasper said by phone.
Individuals should be mindful of how TFSA withdrawals affect your contribution room for the year. All TFSA contributions – including replacing or re-contributing money that was withdrawn – all count towards the annual contribution limit, which was $6,000 in 2022. No contribution room is lost though, it’s simply carried over to the next year.
“Never pass away with a large RRSP or [Registered Retirement Income Account]. That's the ultimate price to pay,” Salgado said.
The tax differences between an RRSP and TFSA also extend to the death of the account holder.
In general, money in an RRSP is deemed to be cashed out upon death and fully taxed, a huge tax implication in most cases, unless a spouse is named as a beneficiary and the money is transferred into their RRSP. TFSAs are not taxed upon the death of the account holder.
“The money in an RRSP also goes to a surviving spouse. But if that's not the case and it goes to a beneficiary, then it's taxable. On top of that, it could be probated, depending on the size of the RRSP and the stipulations in the will,” Gasper said.
“A Tax-Free Savings Account is not probated and it goes directly to the beneficiaries. It's a huge opportunity for estate planning both from a successor standpoint and from just a ‘passing down money to beneficiary’ standpoint because the money goes to the beneficiaries completely tax free.”