September 7, 2016

With students heading back to school and all of us moving into a different type of routine, this is a great question to ask around the family dinner table. A blank stare means you just may have a lively discussion.

I remember when an individual could earn up to $100,000 of Capital Gains tax free! – that all ended in 1994 – those were the good old days! Of course I was in my 30’s paying a mortgage and raising two kids so I didn’t have much money to invest. So along comes the Tax Free Saving Account and the good old days are kind of coming back.

RSP and TFSA strategies offer significant tax benefits but from different perspectives. It’s important to understand the differences and use them accordingly.

A TFSA can be used a number of ways – while an RRSP is typically only for long term investments, or for first time home buyers (see why below) A self-directed TFSA can hold short and long term investments. Investments held in both an RRSP and a TFSA grow tax free. However, RRSP contributions receive a tax deduction and are taxed as income (100% taxable) when withdrawn. TFSA contributions do not receive any tax deduction at contribution but are withdrawn tax free.

The main advantage of an RRSP is the tax deduction of each contribution (up to an individuals’ maximum allowable) – and the long term tax free growth until withdrawal. This allows you to invest more (due to the tax refund) and have this amount growing in your account. You would not want to use an RRSP for short term savings because of the tax impact of a withdrawal (unless buying your first home – under the Home Buyers Program – see below!)

A TFSA is ideal for short to medium term savings – a car, a future trip, renovations or retirement etc. If the plan is to use funds in 1 to 3 years, there are investments providing returns better than savings accounts – if you can accept a little volatility. These investment returns can all be earned tax free in a TFSA. The decision to use a TFSA for long term savings (retirement) depends on a number of factors and variables – beyond the scope of a short article. However, it would not be wrong and would not limit future RRSP contributions to start saving in a TFSA and be able to decide later to move money to an RRSP when income and tax deductions would be greater.

If you were 18 in 2009 your maximum allowable contribution room in a TFSA is $46,500 this year and will grow by $5,500 each future year until a Federal Budget stops it. What’s also great is if you contributed the maximum $46,500 and earned a return of 3% and withdrew all of your original contribution and the growth – you could re-contribute the amount you withdrew back into your TFSA after the end of that calendar year!

A TFSA could be for short term or long term savings purposes and how you use yours depends on how much extra cash you have, how many years before you might start withdrawing, your sources of income in retirement and your tax rate at withdrawal.

Generally, if you expect your tax rate to be higher or about the same in retirement then maximizing contributions to a TFSA first before the RRSP is recommended. Investments in the TFSA should then be considered long term and growth oriented.

Couples that use retirement income splitting typically pay less tax in retirement even when drawing healthy incomes, so in most cases, maximizing an RSP for long term retirement income planning is still preferred. But any extra cash for short or long term savings should go into a TFSA.

However, if you are single before retirement and plan to stay that way, the TFSA needs to be considered for long term retirement income planning. When too much has been invested in an RSP or merged with a deceased spouse’s assets, no income splitting is possible and higher tax in retirement is possible – along with Old Age Security claw back!

If you have extra cash, no or little debt, have maxed out your RSP contributions then using a TFSA for short term financial goals or long term retirement income planning is recommended.

If you are saving for a car or any other short term financial goal (and don’t have a lot of extra cash) then using a TFSA may be ideal again – unless you are using the TFSA for your long term plan.

If you are a first time home buyer and saving for a down payment on a home and you have a lot of extra cash, then contributing to an RSP may be your best option as you get a tax deduction and can withdraw from the RSP without penalty – certain timing rules regarding contributions and withdrawals apply.

Under 30 somethings have a real opportunity to create a tax free retirement income. For most other than the professionals with high incomes, using a TFSA may be their best long term retirement planning strategy. Contributing $10,000/yr. for 30 yrs. at 8% grows to $950,000. Which, given expected inflation will not be enough to fund a 40 year retirement but it’s a great start! The disadvantage of a TFSA is it’s too easy to withdraw the hard earned savings.

RSP and TFSA investment accounts offer us another way to save tax – but using them correctly and with some thought is recommended. Each individual’s tax situation needs to be considered before a long term strategy is put in place.   A competent Financial Planner is always a good resource to help!

Richard WR Yasinski CFP