One of the most common questions we get from clients is whether they should invest in a TFSA or an RRSP. They both have their advantages but depending on your situation, one might be better than the other. The RRSP offers greater tax benefits under the right circumstances but the fact that you have to pay income taxes when you take out money from it makes it less flexible. The TFSA may not provide as many tax benefits as the RRSP, but since taking money out of it has no tax consequences, it's much more flexible.
When should you use an RRSP?
RRSP contributions are tax-deductible. The contributions you make are deducted from your income for tax purposes. In other words, if you make $100,000 this year but add $10,000 to your RRSP throughout the year, you'll be taxed as if you made 90,000$ of income that year. Thanks to the tax deduction, if your income taxes are around 40%, you'll be getting a ~$4,000 tax refund after filing your taxes. However, since RRSP withdrawals are taxed like income, you'll eventually pay taxes on the withdrawals, but at a lower tax rate in the future if your income is lower at retirement than throughout your working years. Very important: to use the RRSP properly, you need to make sure that your tax bracket is high when you're contributing to it but that your tax bracket is low when you withdraw from it.
You should generally invest in an RRSP if:
- You're investing for retirement, are making more than $50,000 a year and don't expect your income to grow significantly.
- You're investing for retirement and are making over $90,000 a year.
- You're investing towards your first home, are making more than $50,000 a year, and plan to use your RRSP for a Home Buyer's Plan.
- You're investing towards your education, are making more than $50,000 a year, and plan to use your RRSP for a Lifelong Learning Plan
When should you use a TFSA?
The TFSA is a simpler tool that allows your investments to grow tax-free but doesn't provide the tax-deduction benefits of the RRSP. It's ideal for objectives that are earlier than retirement but can also be used for retirement in certain cases.
You should invest in a TFSA if:
- You're investing towards an objective that is sooner than retirement (a home, wedding, vacation, car, etc).
- You're investing for retirement and are making less than $50,000.
- You're investing for retirement, are making more than $50,000, but expect your salary to go up significantly. Using a TFSA in this case allows you to use your RRSP contribution room later, when you're at a higher tax bracket, to take advantage of a greater tax deduction.
Pro tip: If an RRSP is right for you, consider maximizing your RRSP contributions to get a large tax refund and put that refund into your TFSA. That way, you have more money working for you and you'll have a mix of long-term retirement funds (RRSP) and flexible funds (TFSA).
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