Tax Free Savings Account or RRSP?
We are often asked the question, “Should I invest in a TFSA or an RSP?” The simple answer is both! When used together these two investment vehicles make a powerful planning combination.
A Registered Retirement Savings Plan is a terrific way to save for retirement. Retirement is usually a relatively long way in the future, which allows for a conservative growth strategy and up to 40% of contributions are not going to the government in taxes. RSPs are tax exempt, only withdrawals are taxable. Assuming the withdrawals do not begin before retirement, taxes payable will be lower due to the additional deductions allowed for those over age 65. (the personal deduction, age deduction and the pension income deduction for those over age 65 was $19,003 for taxpayers over 65)
The structure of a Tax Free Savings Account is quite different from an RRSP. They should really be named Tax Free Investment Accounts, as the investment is not limited to a low interest savings account. A TFSA can hold the same kinds of investments as an RRSP. Deposits are not tax deductible but the growth is tax free. Withdrawals can be made from the TFSA at any time with no tax consequence. Withdrawals made today can be returned to the TFSA in following calendar year i.e. a withdrawal in 2015 can be put back in 2016. For 2015 the maximum deposit to a TFSA is $5,500.00 per person over age 18. The accumulated total amount that can be deposited to date is $36,500.
These unique features of the TFSA make it an excellent investment vehicle that compliments the RSP. Having both a TFSA and a RRSP just makes sense. Taking a bit more risk for higher return in the TFSA allows the RSP to be invested conservatively for less risk. The TFSA can be used as an emergency fund for those unforeseen events that occur when cash is needed, eliminating the need to withdraw funds from an RRSP, which can be costly.
A TFSA is also a very useful tool for managing debt; funds accumulated in a TFSA over the course of a year can be used to pay off a mortgage when the extra payments are allowed annually. For older individuals, retired or working, a TFSA is the perfect vehicle to invest those extra dollars that are not needed right now but maybe needed in the future.
The second question often asked is, “which will provide the most tax free income at retirement the RSP which is fully taxable or the TFSA which is not taxable at all?” Here is a simple case study that compares two investments one in an RRSP and the other in a TFSA and the impact on income at age 65.
A RSP contribution of $5,000 invested annually at six per cent for 40 years (i.e. age 25 to 65) would accumulate about $774,000. Assuming a 30% tax bracket the same investment made in a TFSA after tax has been paid on the investment would accumulate $542,000 over the same time period.
At age 65 the individual would begin taking income from both investments at five percent a year. The RSP income would be $38,700 fully taxable. Using today’s allowable deductions the portion that would be taxable would be $19,697 ($38,700-19,003) The personal deductions for a taxpayer over age 65 are $19,003 for 2014. The tax payable at 22.70% is $4,500.00, net income after tax, $34,200.00. On the other hand the income from the TFSA at 5% would be $27,100 all non taxable, giving the RRSP has a $7,100 advantage.
This calculation does not take into consideration Old Age Security and Canada Pension benefits . To maximize the tax advantage some planning would be required. Delaying the withdrawal from the RRSP as long as possible or limiting the withdrawal in the early years to minimize tax are two options. The key point, however, is the value of the tax deduction in an RRSP should not be overlooked.
The best way to save is to have a monthly savings goal that is automatically invested. Set a goal to save 1% of gross annual income monthly. A well planned savings regimen taking advantage of the benefits these investment tools offer, will create wealth and the freedom to choose the lifestyle that is most attractive at retirement whatever age that may be.
Regardless of age, making wise investment decisions can make a difference. Asking an independent financial advisor for planning assistance does lead to better returns. Take action today and call an advisor take advantage of all the opportunities that are available.
– Colin J. Campbell CFP, CLU, is managing partner of Guidance Planning Strategies Ltd. in Cranbrook BC. Independent insurance and mutual fund brokers specializing in helping families and entrepreneurs create wealth and keeping it for generations.