If you have limited investment funds available and can contribute only to a tax-free savings account or a registered retirement savings plan, which one offers the better tax savings?
A TFSA is funded with after-tax dollars, so you don’t receive a tax deduction for contributions. You can make withdrawals from a TFSA without paying taxes, and any withdrawals are added back to the allowable TFSA contribution room for the next year.
Withdrawals from an RRSP are fully taxed at your marginal rate with a variable automatic withholding tax of 10 to 30 percent depending on the amount withdrawn.
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So for example, a $10,000 withdrawal returns $8,000 after the de-duction of a 20 percent withholding tax. Any remaining tax owing or overpayments are settled when filing the year’s income tax return. TFSA withdrawals are tax-free, so you receive the full amount without further liability.
Attribution rules, such as income splitting, do not apply to a TFSA. The higher income spouse can gift cash to a lower or non-income earning spouse, children older than 18, parents or grandparents to deposit in the lower income earner’s TFSA account without triggering tax consequences.
Attribution rules do apply to gifting to an RRSP, which can trigger additional taxes only if the principal is withdrawn.
A TFSA also provides a major benefit if you are a middle-income senior. A TFSA also provides a major benefit if you are a middle-income senior.
Withdrawals from a TFSA will not be included in income for tax purposes. This means such withdrawals will not trigger clawbacks of income-tested benefits for Old Age Security, Guaranteed Income Supplement and GST/HST credits .
RRSPs provide a tax deduction up to your maximum allowable contribution room for the year the contribution is made. You receive the benefit now, but in effect this is a tax deferral program because withdrawals of contributions and investment income are taxed when you take money out of your plan.
You also have to collapse your plan in the year you turn 71, which is not a requirement of a TFSA.
Simple rules of thumb can be used to determine whether an investment in a TFSA or an RRSP offers the better tax savings. They largely relate to your current tax bracket compared to your anticipated tax bracket when you start to withdraw funds from either plan.
For example, if you are in a higher tax bracket now but expect it to be lower in the future, the advantage may go to investing in an RRSP. Any RRSP contribution reduces your taxable income, so you pay less tax at the higher rate.
When you withdraw the funds in the future at a lower tax rate, you are paying less tax than had you paid it at the current higher rate.
The reverse happens if you anticipate being in a higher tax bracket in the future. Investing in an RRSP now results in a lower tax benefit while setting yourself up for higher taxes on withdrawals in the future. Therefore, it may be better to invest in a TFSA.
If you expect that your tax bracket will be the same in the future, then the tax benefits of a TFSA and an RRSP will be relatively the same.
Everyone’s personal situation is different, so it’s best to discuss the matter with a tax specialist to determine the right investment for you.
