RRSP vs. TFSA
How to figure out your best savings strategy.
In 2009, the Canada Revenue Agency introduced the tax-free savings account (TFSA) as a way to entice Canadians to invest their savings instead of hoard their cash. Over the past three years there has been some ongoing confusion on whether it's better to invest money in a registered retirement savings plan (RRSP) or in a TFSA.
Experts agree that these two different types of accounts need not compete, but should complement each other in a well-balanced investment portfolio.
Investing for retirement in a RRSP
A RRSP is an investment account that is designed for the purpose of saving for retirement while at the same time offering Canadians two main tax advantages.
According to Toronto-based Kimberly Beck, an analyst in the business and fiscal planning branch of the Ontario government, "the main advantage of investing in a RRSP is that it allows for a larger amount of money to grow in a tax-favourable manner."
All of the income (or profit) earned on the RRSP investments over the years is completely tax sheltered. This means that investors will never have to declare or pay tax on the interest, dividends, and capital gains earned on the investments in their RRSP.
The investments continue to grow tax free in a RRSP until the money is withdrawn during retirement. Beck says that the advantage of this is that "the tax on RRSP investments is paid at the time of withdrawal, which is meant to be during the retirement years at a lower tax bracket."
What's more, RRSP contributions receive a tax deduction in the year the money is invested.
All Canadians who are under the age of 71 and have an annual earned income are allowed to contribute into a RRSP. Each year investors can contribute up to 18 per cent of their previous year's salary and any unused contribution room is carried forward indefinitely. The total annual RRSP contribution limit can be found on your personal Notice of Assessment.
Although there are advantages to investing in a RRSP, there is also a major disadvantage. Since the main purpose of a RRSP is to save for retirement, if you withdraw money early, you'll pay a penalty. The amount of the penalty varies depending on the amount of the RRSP withdrawal, as well as your province of residence. That said, under certain circumstances (such as returning to school full time or buying your first home) you can withdraw money from your RRSP tax free.
Saving for an emergency in a TFSA
All Canadians over the age of 18 can contribute up to $5,000 per calendar year into a TFSA. Similar to a RRSP, any unused TFSA contribution room is carried forward indefinitely. If you've never invested in a TFSA, you can currently contribute a total of $20,000, which equals $5,000 per year from 2009 until 2012.
The main advantage of investing in a TFSA is that all investment profits are earned tax free and you can use your savings for any purpose at any time. Unlike a RRSP, you can withdraw money from a TFSA at any time without penalty; however, you do not receive an income tax deduction when investing money.
Beck confirms that diversity is a major advantage of investing in a TFSA. She says, "The TFSA has the flexibility to be used for a rainy day fund, emergency savings, to supplement retirement income, or whatever a person needs from their savings."
A TFSA can be opened with most Canadian financial institutions and investment brokerage firms. Like a RRSP, there are several different investment options within a TFSA, including cash, guaranteed investment certificates (GICs), mutual funds, stocks and bonds. Since interest income is taxed at the highest rate, investors should try to purchase interest-bearing investments (such as bonds, GICs, money market instruments and cash) in their TFSA.
When deciding to invest in a RRSP or a TFSA, Beck says, "There is no easy, one-size-fits-all answer as to which investment strategy a person should take." Both investment accounts have their benefits and it is important to understand your own financial situation as well as your priorities to help decide which type of investment account gets you closer to achieving your goals.
Tahnya Kristina is a writer in Montreal.
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