I’ve recently joined Bruce Kelsch’s team in the role of an Associate Wealth Advisor.
In addition to working with clients on wealth planning goals and objectives, I intend to write a quarterly blog on tax tips and tidbits that you hopefully find of interest and value. In this first edition, I’ll start by considering the RRSP or TFSA allocation conundrum.
So what’s this conundrum about?
It is the start of a new year and therefore a good time to think about investing and opportunities to minimize income taxes. Over the years, I’ve worked with hundreds of clients and not one has ever fancied writing a big check to the tax man in Ottawa each spring (can you really blame them?).
A common question this time of year is often where to allocate an investment contribution. In a perfect life or simple world, it is likely best to max both the RRSP and TFSA, however, if resources are limited and only one is an option, you might have to prioritize.
So this brings us to the question, which is the best option for your retirement investments?
The simple answer is it depends.
If you prefer a to the point summary without reading all the details, consider the following:
- If in doubt start with a TFSA as contributions can be moved to an RRSP later.
- If income and tax rates are currently low to moderate, start with a TFSA.
- If income and taxes are high and likely to be lower at the time of withdrawal, consider an RRSP and invest the refund in a TFSA.
A quick refresher
Now for those that want a bit more detail!
It is not my intention to provide an in-depth overview of RRSPs and TFSAs, however, if you need a little nighttime reading, I’d be delighted to send you a good article or two.1
In a nutshell, the eligible investments in each type of registered account are essentially the same. The accounts, however, differ in a few areas including but not limited to the tax treatment of contributions, the taxation of withdrawals, and annual contribution limits.
A contribution to an RRSP is eligible for an up-front tax deduction that typically reduces your taxes as it generates a refund. In contrast, a contribution to a TFSA is not tax deductible such that there is no immediate tax benefit. The income and gains generated in both the RRSP and TFSA, however, grow and benefit from tax-free growth and compounding while invested (this is important to remember).
Now at some point down the road, money is likely to be withdrawn from the RRSP, or it comes time to convert an RRSP to an RRIF (mandatory at 71). It is surprising how many investors forget this and get angry or upset. Why you ask?
Subsequent to conversion, there are minimum withdrawals that commence and the full withdrawal is considered taxable income, even though a portion of it represents the capital that you contributed. In contrast, a withdrawal from a TFSA is not taxable, and as such, a TFSA provides a bit more flexibility, but remember, it doesn't give you the initial up-front tax deduction.
In regards to the contribution limits, the maximum RRSP contribution is based on the lesser of 18 percent of the prior year earned income and the contribution limit ($26,230). The annual contribution limit this year for a TFSA is $6,000 with total individual contribution room since inception now at $63,500. If you have unused RRSP or TFSA contribution room, it can be carried forward.
Okay, now help me decide!
I’ll start by making a simplified assumption that the end objective is to maximize after-tax income, presumably in retirement.
Next, to help you make the best decision, here are 5 things to further consider…
- How much surplus cash do you have available to invest, are both options?2
- Is there a possibility of needing invested funds prior to retirement? A TFSA is more accessible, however, consider if this is a comfort or a hindrance.
- Is your income currently high such that you are in one of the top marginal tax brackets, think in excess of 40 percent? If so, this will assist in generating a larger tax refund on an RRSP contribution than if your income is nominal.
- In the future, at the time of withdrawal, do you expect to be in a lower marginal tax bracket? If so, the income inclusion of the full withdrawal amount may not necessarily have a punitive impact (it still gets taxed).
- In the future, at the time of withdrawal, do you expect to be in the same tax bracket? If so, TFSAs and RRSPs should work equally well (if only life were that simple).
Now this isn’t an exhaustive list of things to consider, unfortunately, life is more complex than considering a simple 5 questions.
However, starting with some assumptions or questions is a reasonable approach. It seems easy enough to make a few assumptions…
- Guess your marginal tax rate in 10, 20 or 30 years down the road, easy peasy!
- How about future tax rates, they are surely bound to stay the same, right?
- What about income splitting, clawback rules and so on, will these change?
Now, I’m an accountant, I like numbers, I enjoyed calculus in high school, but sheesh, the math and assumptions look like they might be a bit more complex, right?
Time to wrap this up!
In either case, growing money tax-free through regular contributions is a great way to accelerate portfolio growth and better than keeping it under the mattress. Therefore, making a decision between the options as opposed to an indecision in search of the perfect solution will leave you better off.
Now is a great time to make contributions too given recent noise in the market, so let this serve as a friendly reminder for that.
If you still aren’t sure which option is best, give me a call and we can help you make an informed decision. If you would like to make a contribution or set up an account, let us know.
I can be reached at firstname.lastname@example.org or 604.981.6681.
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1 If you wish to receive any other early tax tips or details on tax changes, send me an email or give me a call.
2 If you do not have surplus cash, an in-kind contribution can be made to your RRSP or TFSA, however, a transfer from a non-registered account is considered a taxable disposition.