Retirement seems so far away and you probably haven’t thought about your saving strategy in a very long time. That is, until someone asks you if you’re using a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA) to save up for your golden years. You realize that this is a great question and that you’re not sure.
RRSPs and TFSAs share many similar characteristics that can benefit you in reaching your financial goals. The main benefit of BOTH types of accounts is that your investments will grow without being taxed. Your interest, capital gains, dividends, and other payments will not be taxed and the extra non-taxed portion can be invested further and grown. In the long-run, you’ll notice larger than usual returns and this is what makes both of these products essential for retirement savings.
Another benefit is how easy it is to set up these accounts. You can walk into a bank and walk out within 30 minutes. It’s also easy to make changes, deposits and withdraws.
Registered Retirement Savings Plans (RRSPs)
RRSP savings accounts were introduced in 1957 and have become a staple in retirement saving strategies since. The biggest benefit of RRSPs is that you are able to defer the income tax on contributions until you remove the funds. The key word is “defer”, because you still need to pay taxes on the contributed income when you withdrawal the money from the RRSPs. To get a rough estimate on the amount of the deferred income tax, you can play with a simple online income tax program (ex. Ufile) or use the most recent income tax table (refer to below). I’ve also done an example here https://www.ffcoach.ca/personal-finance/rrsp-deadline/
RRSPs can also benefit Canadians through the Canadian Home Buyers Plan and the Lifelong Learning Plan. Simply, the Home Buyers Plan lets you use your RRSPs for a house purchase and the Lifelong Learning Plan allows you to use your RRSP funds towards an accredited education. RRSP funds can also be withdrawn during low-income years with minimal income tax consequences.
The issue with RRSPs is that the rules can be rigid when you want to take your money out. If you withdrawal your funds before you are allowed to, then you will be charged an upfront withholding tax that ranges from 10-30% (depending on the amount withdrawn) and the funds will be taxed as income for that tax year. Another rule of RRSPs is that you are forced to start withdrawing the money when you reach the age of 71. These RRSP withdrawals can also reduce your government pension plan such as Canada Pension Plan (CPP).
Another interesting downside of investing in RRSPs is that they may become redundant if the new Ontario Registered Retirement Plan (ORPP) is implemented. Although this legislation has not been passed yet, it seems likely that it will. This new retirement plan may reduce the importance of RRSPs. Money Sense Magazine has stated that the returns from this plan, in addition to government plans may be adequate for retirement needs. Next week I will investigate the ORRP further.
Tax-Free Savings Accounts (TFSAs)
Tax-Free Savings Accounts are great because they are a lot more flexible than an RRSP, and when you withdraw the money you do not have to pay taxes on it. This is very helpful, because if you withdraw funds in retirement it won’t affect your government pensions. The downside is that you don’t get to defer taxes (like RRSPs).
All this talk and still unsure what’s best for you? Well, everyone will be different, but the key factor is how much money you plan to receive upon retirement compared to what you earning now (in present value). If, for example, you are earning very little right now, then it doesn’t make sense for you to contribute into your RRSPs, as you will get a minimal return. However, if you earn quite a bit now and expect to earn a lot less in the future, then contribute to your RRSPs. Assuming that tax rates don’t fluctuate much in the future, you can determine future taxes. There’s also a possible RRSP reverberation effect when you contribute the income tax saved by your past RRSP contribution.
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