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RRSPs vs TFSAs: Which Should You Invest In?

There’s no question that Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs) are both vital parts of any solid personal finance plan. Under ideal circumstances, Canadians should maximize their available contribution space with RRSPs and TFSAs every year, putting that money to work by investing it wisely.

In reality, of course, not everyone has the financial freedom to take advantage of every last dollar of available contribution room in a given year.

For those forced to choose and wondering whether it’s better to put their savings into an RRSP or a TFSA, there’s no one-size-fits-all solution. Rather, the appropriate choice depends on your personal situation. Answering a few questions will help you decide whether you’re better off contributing to an RRSP or a TFSA.

RRSP’s – The basics

Up to a predetermined annual limit, contributions to an RRSP are tax deductible, meaning the money you put away for the future helps lower your personal income tax bill in the present. Gains made within an RRSP are tax-free, but the money is taxed when you withdraw it in retirement. However, because most people earn less as retirees than they did while employed, they drop into a lower tax bracket and pay lower rates.

The annual contribution limit for an RRSP is 18 per cent of your income, or the yearly fixed maximum, whichever is lower. If you’ve got unused contribution space from past years, you carry it forward and use it anytime. Be careful not to contribute too much: over-contributions beyond a $2,000 buffer amount are taxed at a rate of one per cent a month.

With a few exceptions, such as paying for education or a ‘first-time’ home purchase, you can’t take money out of an RRSP before retirement without paying a withholding tax penalty. The size of the penalty depends on which province you live in, and how much you withdraw. By and large, it’s an unwise financial strategy to make early withdrawals from an RRSP.

TFSAs – The basics

Tax-Free Savings Accounts allow Canadians to contribute up to $6,500 each year into an account where any gains are untaxed. There’s no tax deduction on the contribution amount like there is with RRSPs, but you’ll never pay a penny of tax on earnings made in a TFSA, even when you withdraw your money.

Different annual contribution amounts have applied in various years since TFSAs launched in 2009, from $5,000 in the early years to a high of $10,000. As with RRSPs, unused contribution room is carried forward and can be used anytime.

Unlike RRSPs, there’s no penalty for withdrawing funds from a TFSA, so the accounts can be a useful vehicle for saving towards short- and medium-term goals. If you do withdraw money from a TFSA, you can pay it back the following calendar year. Like RRSPs, however, there’s a penalty for over-contributing, so be careful how much you put in, and when.

How to decide between RRSPs and TFSAs

If you’re choosing between the two, these questions will help you determine whether you’re better off putting money into an RRSP or a TFSA.

What are you saving for?

Both RRSPs and TFSAs are excellent vehicles for retirement savings. However, if you’re planning on accessing your savings before then, say for a new vehicle or a home renovation project, a TFSA is a better option because you won’t pay any withdrawal penalties.

How much income do you earn?

If you earn $50,000 or more in annual income, your RRSP contribution makes a meaningful difference in reducing your income tax bill, because the amount you contribute is tax deductible. However, if you’re a low-income earner, on maternity or paternity leave from your job, or a student, you’re not paying much income tax to begin with, so there’s less value in seeking a deduction. Below $50,000 in annual earnings, you’re probably better off contributing to a TFSA.

One strategy for low earners is to contribute to a TFSA and accumulate RRSP contribution room, then withdraw from the TFSA to make RRSP contributions once their income increases and they have greater need for income tax relief.

Does your employer match or top-up retirement savings?

Contributions to most company pension plans count as RRSP contributions, too. Some employers offer generous matching or top-up programs that are basically free money for the recipient. If you can use available savings to generate a greater RRSP contribution total thanks to your employer’s generosity, you should definitely take advantage of it.

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