If you’re scrambling to meet the March 1 registered retirement savings plan (RRSP) deadline take a step back – for a moment – and consider this: the long-term tax savings in a tax free savings account (TFSA) could be greater than the short-term tax savings in a RRSP.
The TFSA has come into it’s own as a legitimate tax saving tool now that the total contribution limit has reached $25,500. Under Canada Revenue Agency rules any investment gains in the plan are not subject to taxation - ever. If you invest well over the years, that could be a lot of tax free money.
There is no deadline to contribute to your TFSA because - unlike an RRSP - the contribution can not be deducted from your taxable income. Where the TFSA trumps the RRSP is the fact that any RRSP contribution, plus gains, are fully taxed when withdrawn (although the taxes are expected to be minimal because the plan holder is intended to be in a lower tax bracket in retirement).
So, which is better?
The answer is both. We may be tempted by the instant gratification of an RRSP rebate, but the real answer requires a look into the future when plan holders may withdraw their savings.
Canadians of all ages are taxed on a graduating scale. The first $30,000 of income in one year, for example, is taxed at a much lower rate than the next $30,000. A RRSP with too much money can generate a bigger tax bill when the money is withdrawn. By the time the plan holder turns 71 the RRSP must be converted to a registered retirement income fund (RRIF) and a mandatory minimum must be withdrawn. If that minimum is too high, plan holders could have a portion of their Old Age Security clawed back by the government.
The trick to collecting your full OAS entitlement and keeping your income in the lowest tax bracket possible is to withdraw as little taxable income as possible.
That’s not easy when you need money to live, but if you have savings that are not subject to taxation you only need to be poor in the eyes of the Canada Revenue Agency.
A TFSA provides that tax-free income and can subsidize any shortfall in your RRSP.
Bring it on home
TFSAs have only been around for five years but another type of TFSA has existed much longer for homeowners.
As you pay down your mortgage, you accumulate equity in your home. Over the long term your property also appreciates in value. According to the Canada Mortgage and Housing Corporation the value of the average Canadian residential property rises by more than 5 per cent each year over a 30-year period. If the home is your principal residence that gain is not taxed when it is sold – much like a TFSA.
Retirees who downsize, or sell their homes and rent, can also use that tax-free money to subsidize any shortfall from an RRSP and remain in a lower tax bracket.
Homeowners who wish to remain in their houses also have the option of borrowing against their properties through a secured line of credit or a reverse mortgage.
The best of both worlds
There’s no need to fret if you miss the RRSP contribution deadline for 2012. Any contribution space can be carried forward to future years – perhaps when you are in a higher tax bracket and can realize higher savings.
If you’re still torn between your RRSP and TFSA consider a compromise. Contribute to your RRSP and put the tax rebate in your TFSA – simple as that.