RRSP vs. TFSA

In a perfect world you would max out both your Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA). But guess what? The world lacks perfection. If you’re wondering where to contribute your cash this year, consider the differences, pitfalls, and advantages of each.

RRSPs: The good, the bad, the ugly?

Good: Defer tax during your highest earning years and pay the tax man years later when you’re retired, and hopefully in a lower tax bracket. Investment earnings accumulate on a tax-sheltered basis.

Good: Get a tax refund by contributing up to 18% of your income before the March 1st deadline. Use the refund to pay down consumer debt, make a mortgage payment, or contribute to your TFSA.

Good: Can’t contribute this year? Carry forward the unused portion to future years.

Good: Use the Home Buyers’ Plan (HBP) to borrow up to $25,000 tax-free from your RRSP to buy or build a home.

Bad: RRSP withdrawals are taxed in the year the money is taken out, and you cannot recontribute that cash once it is withdrawn. Exceptions are the Home Buyers’ Plan and the Lifelong Learning Plan, as long as the money is repaid on schedule.

Bad: Your RRSP must be converted into a Registered Retirement Income Fund (RRIF) by December 31st in the year you turn 71, and you must withdraw a minimum amount of retirement income from your RIFF each year. By age 71 your annual mandatory minimum payments are more than 7% and increase each year. If your savings are modest, you could run out of RIFF funds.

Ugly: RRSP or RIFF withdrawals can increase your income substantially, making you ineligible for means-tested benefits such as the Guaranteed Income Supplement (GIS). If your net individual income is greater than $66,733 in 2010 ($67,668 for 2011) your Old Age Security (OAS) pension will be clawed back.

TFSAs: The good, the bad, the ugly?

Good: Canadian residents can save up to $5,000 per year in a TFSA and watch their savings grow tax-free. Unlike the RRSP, you don’t need to earn an income to contribute, but you must be at least 18 years old to open an account.

Good: Like the RRSP, you can carry forward unused contribution room from previous years, making the total maximum TFSA limit $15,000 per person in 2011.

Good: Unlike an RRSP, withdrawals from a TFSA are tax-free. Any money withdrawn is added to your contribution room in the next calendar year, making is possible to recontribute that cash.

Good: Unlike an RRSP, you are not required to convert your TFSA to a RIFF-like income plan or withdraw a mandatory amount. TFSAs are far more flexible than RRSPs.

Good: Unlike the RRSP, your TFSA withdrawals won’t affect your eligibility for federal income-tested benefits and credits, such as the Canada Child Tax Benefit, the GST credit, the Age Credit, Old Age Security (OAS), or the Guaranteed Income Supplement (GIS) benefit. This makes the TFSA an excellent choice for seniors who could face an OAS clawback due to mandatory RRSP withdrawals.

Bad: Unlike your RRSP, contributions to a TFSA are not tax-deductible on your income tax return, and you won’t get a refund.

Ugly: Around 70,000 Canadians over-contributed to their TFSAs in 2010 by misinterpreting the TFSA rules. Contribute or replace too much cash in a given calendar year and you’ll pay a 1% per month penalty on the overage.

Your Turn: Are you contributing to your TFSA, RRSP, or both this year?

Credit: Kerry K. Taylor