Let's dive in
TFSA or RRSP? Hmmm
A Key Concept 1:
The amount of after-tax cash you could build with an RRSP or TFSA over time is the same if your tax rate is the same when you ultimately withdraw the money.
It matters what your tax rate is now and what it will be in the future.
Key Concept 2:
Understand your tax refund.
The tax you don't pay on the funds you contribute to an RRSP is simply being deferred to a later point when you ultimately pay tax, either when you withdraw funds from your RRSP or RRIF or upon death.
In geek words, the refund is the present value of the future tax payment.
The power of the RRSP:
- An RRSP helps you lower your tax bill today by allowing you to deduct RRSP contributions from your taxable income.
- Investments grow in a tax-free environment.
- You can make up for missed contribution room from previous years.
- Income splitting benefits; you can split RRIF withdrawals with your spouse or partner.
- Knowing that taxes must be paid on RRSP withdrawals creates a psychological barrier that keeps people from using the money before retirement.
Investing in your RRSP is always a good idea when your current tax bracket is higher than it will be in retirement.
How to use your tax refund:
- Pay to get or update your Will, Power of Attorney
- Pay down debt
- Put suitable disability or life insurance in place
- Reinvest back into your RRSP
- Reinvest into TFSA
- Reinvest refund into an RESP for your kids
- Build up an emergency fund
Pro Tip:
- Automate monthly contributions to your RRSP account.
and remember this...
Spending your refund now is the same as taking out a loan against your future earnings with an interest rate equal to the projected return on your RRSP.
So.... use your refund productively.
Okay now, the TFSA account:
TFSAs are "tax pre-paid" savings plans. You use after-tax funds to make TFSA contributions.
The amount you can contribute to a TFSA is based on your "TFSA contribution room."
Although some people might be afraid to use it, the TFSA can be a powerful retirement investing account.
TFSA accounts will grow to meaningful amounts over the following years and decades.
Canadians are obsessed with the instant gratification of the "tax refund" attached to contributions to RRSPs.
The Power of the TFSA:
- Investments grow tax-free.
- Withdrawals are tax-free
- TFSA funds can be withdrawn at any time, and the regular withdrawal amount can then be re-contributed in a future year.
- Flexibility in creating retirement income as withdrawals are tax-free, are not included in your net income and won't affect government benefits and tax credits.
If your business owner only pays yourself in dividends, the TFSA may be your only option for a tax-free environment for growth.
Wow, that was a lot of information. I didn't sign up to read a book this morning, Matt!
So should I contribute to my RRSP or TFSA, or both?
It should go without saying that Canadians who have the funds would be wise to maximize their RRSP contributions as well as their annual TFSA contributions.
Even two people in the same tax bracket today may reach different decisions regarding how best to divide which savings vehicle should take priority.
Understanding which strategy or mix is best depends on your unique situation and goals.
Why is the answer always....... well, it depends!
Sorry, that's life; there is more gray than black or white.
In summary:
Use the RRSP if you are in a high tax bracket now, and use your refund wisely.
The TFSA is a better option for many lower-income Canadians than the RRSP.
Sometimes paying tax now to contribute to your TFSA means less tax over the long run.
Prioritizing your TFSA can provide flexibility in creating your retirement income.
As TFSA contribution limits continue to grow, it may become the retirement vehicle of choice for many more Canadians moving forward.
As always, make informed decisions with your money!
I write for business owners to encourage them to improve their wealth, health, relationships, and live with a sense of purpose.