Since the introduction of TFSA (Tax Free Savings Account) in 2009, we have been hearing all kinds of theories about the ultimate use of such a tool versus the maximization of our assets through an RRSP (Registered Retirement Savings Plan). This chronicle will help you to see more clearly.
The features of an RRSP
1-Deductible contribution
Any contribution made in the year or in the first 60 days of the following year up to the maximum of the available contribution room is deductible from the taxable income of the year or any future year.
2-Non-taxable return
Returns of any kind, such as interest, dividends, capital gains, are not taxable on an annual basis.
3-Taxable Withdrawal
Unless special withdrawals under the Home Buyers’ Plan (HBP) or Lifelong Learning Plan (LLP) as discussed below, each withdrawal from an RRSP is a fully taxable income that is added to other income in the taxation year.
Taxes will be withheld by your financial institution at source from any withdrawal from the RRSP.
4-Contribution room
Everyone receives RRSP contribution room equal to 18% of the previous year’s earned income up to the current year’s maximum ($ 26,500 in 2019). However, a person participating in a registered pension plan or a deferred profit-sharing plan will have a pension adjustment (PA) that will reduce the contribution room. Income qualifying as earned income is mainly: salary, net income from self-employment, net rental income, taxable support payments.
5-Ultimate contribution deadline
A person has until December 31 of the year they turn 71 to contribute to their RRSP or until December 31 of the year their spouse turns 71 to contribute to the spousal RRSP after which it will no longer be possible to contribute to an RRSP.
6-Annuitant or spousal RRSP
A person with unused RRSP contribution room may choose to contribute to their own RRSP (annuitant) or that of their spouse (spousal).
The person making the contribution will, in both cases, be the one to benefit from the tax deduction.
When the RRSP is withdrawn, the tax will be in the hands of the RRSP owner.
However, when a person makes a withdrawal from a spousal RRSP, the RRSP withdrawal will be taxed in the hands of the contributing spouse rather than the owner’s hands up to the amount of the contributions made during the last 3 December 31st.
For tax purposes, a spouse is a married spouse or common-law partner if the conjugal relationship is at least 12 months continuously or as soon as a child is born from this union.
7-Family patrimony act
In the event of the break-up (separation, divorce or death) of the union of a married couple, the rights accumulated in an RRSP will be part of the division of the family patrimony.
Conversely, no mandatory division will be made to the separation of a couple of common-law partners unless they have drafted a common-law agreement providing for such sharing.
8-Taxable at death
The total RRSPs held by one are taxable in the year of death, which can result in significant tax liabilities.
The tax burden can be deferred if the RRSPs are bequeathed to the surviving spouse.
9-Old Age Security Pension (OAS) or Guaranteed Income Supplement (GIS)
The taxable income from withdrawals from an RRSP can reduce or completely cancel OAS or GIS benefits.
10-Use to contribute to TFSA
With RRSP withdrawals always being taxable income, unless you have a zero tax rate, it will not usually be worthwhile to use it to contribute to the TFSA.
11-Eligible investments
There are a multitude of investment choices depending on your investor profile: term deposit, mutual funds, stocks, bonds, exchange traded funds, labor funds (Fonds de solidarité FTQ, Fondaction CSN), etc.
12-Uses
Basically, the accumulation made in the RRSP will be used to finance your retirement.
Exceptionally it is possible under certain conditions to withdraw up to $ 35,000 from your RRSP under the Home Buyers’ Plan and up to $ 20,000 under the Lifelong Learning Plan.
13-Excess contribution
The excess contribution of $ 2,000 is reserved for persons 18 years of age and over.
Beyond $ 2,000 of excess contribution, you will have to withdraw the surplus and pay a special monthly tax of 1%.
14-Interest and management fees
Interest paid and management fees on your contributions are not deductible in the RRSP because the income is not taxable.
The features of a TFSA
1-Contributions
Contributions made to a TFSA do not qualify for any tax deduction and must be made from January 1 to December 31.
The maximum contribution possible is the new room earned on January 1 of the year plus any unused room received since 2009 plus the total withdrawals made before the year in question.
2-Returns
As with the RRSP, the returns obtained are non-taxable.
3-Withdrawals
Withdrawals are never taxable.
In addition, as mentioned above, the amounts withdrawn in one year will be added to the contribution room as of the following January.
4-Contribution room
Any Canadian resident aged 18 and over receives new contribution room every January 1st.
There is no possible contribution to the spouse’s TFSA but it is possible to make a donation to the spouse to contribute to his or her TFSA without the attribution rules apply.
5-Family patrimony
The TFSA is excluded from this partition.
6-Non resident
A non-resident person does not get new TFSA contribution room and can not contribute to the TFSA, even if they have unused rights.
7-Death
The TFSA is fully tax free on death.
The TFSA bequeathed to the spouse will be rolled over and will be added to the surviving spouse’s TFSA.
8-Old Age Security Pension (OAS) or Guaranteed Income Supplement (GIS)
Withdrawals from a TFSA being tax-free, they will have no impact on these annuities.
9-Possible uses
TFSA can be used to contribute to the RRSP without tax impact;
any other project in the short, medium or long term (eg renovations, travel, automobile purchase).
10-Excess contribution
From the first dollar exceeding your TFSA contribution room, you will have to withdraw any excess contribution and pay a special monthly tax of 1%.
11-Interest and management fees
Like RRSPs, these expenses are non-deductible since TFSA revenues are tax-free.
Which one to choose?
The first thing to consider is the reason for the savings you want to make: is it for your retirement or for another project?
If the answer to this question is not retirement, you should not use the RRSP but the TFSA.
If your savings are actually for retirement, then you will need to make a few validations before choosing between RRSP and TFSA.
If your marginal tax rate during the accumulation period in your RRSPs is higher than the one you will have when withdrawing, the after-tax RRSP is more attractive than the TFSA.
If your marginal tax rate during the RRSP accumulation period is the same as the one you will have when withdrawing, the after-tax RRSP is the same as the TFSA.
Although this situation may seem incredible to you, note that for the taxable income range from $47,630 to $87,575, the marginal rate (federal + Quebec) is 37.1%. For example, someone with $80,000 in salary contributing to an RRSP will receive a 37.1% deduction. The same person, when retired, withdraws an amount from their RRSP while their other retirement income is $50,000, the RRSP tax rate will be 37.1%.
In the rarer situation where your retirement income will be higher than it is today (for example as a result of a large inheritance), the TFSA will be a better choice.
For low-income people who will be able to receive the maximum Guaranteed Income Supplement (GIS) benefits, RRSP contributions are not recommended because withdrawals would reduce the GIS. The TFSA is for these people a much better solution.
Each financial situation being different, only a detailed analysis will allow you to use the best accumulation strategy. We will be pleased to help you take advantage of these tools while optimizing your personal financial and tax situation.