This is a guest post by the experts at Ratehub.ca
It’s important to save money, but it also helps if you save in a way that minimizes your tax burden. The less you pay in tax, the more you get to keep for yourself.
Fortunately, the government has created two types of accounts that allow you to reduce your tax bill. What are they, and when should you use them?
Registered Retirement Savings Plans (RRSPs)
The first and best-known account is the RRSP, which were initially designed to help Canadians save for retirement. Ever year, any Canadian with earned income (for example, your salary or rental income) may contribute a predetermined amount to their RRSP. This figure is 18% of your earned income, or a specified dollar value. For 2016, the dollar value is $25,370. As an example, someone with a total earned income of $80,000 is allowed to make an RRSP contribution of $14,400 ($80,000 x 18% = $14,400).
Once money has been placed in an RRSP, it can then be invested in stocks, bonds, GICs, or mutual funds.
One of the main benefits of contributing to an RRSP is that your money can grow tax-free while it’s in your account. For instance, if you buy an investment and sell it for a higher price, you won’t be subject to capital gains taxes, so long as you keep your money in the RRSP. This also holds true for any interest and dividend income you may receive from your RRSP investments.
RRSPs have a second key benefit: they allow you to lower your tax bill. You can deduct your RRSP contribution from your taxable income, which lowers the amount of tax you’ll owe to the Canada Revenue Agency. You’ll likely get a refund and this money should be used to pay down any high-interest credit card debt – not a vacation.
There’s also a third benefit. You can make a tax-free withdrawal from your RRSP to buy a home if you’re a first-time homebuyer or to go back to school. This means you can borrow less (or not borrow any money at all) and reduce your overall debt burden. Although you’ll need to pay this money back, you don’t need to pay interest on your withdrawals.
Tax-Free Savings Accounts (TFSAs)
In 2009, TFSAs were introduced, giving Canadians another way to reduce the amount of tax they pay.
Every year, Canadians who’ve reached the age of majority in their province or territory are allowed to contribute a specified amount to their TFSA. For 2016, the figure is $5,500. As with RRSPs, money placed in a TFSA may be invested in a wide variety of investments. In addition, investment gains and dividends earned aren’t taxable as long as they remain in the account.
RRSPs and TFSAs probably sound very similar so far, but there are some important differences.
When you contribute to an RRSP, you’re lowering your taxable income today because your contributions are tax deductible. But you’re not avoiding tax altogether, you’re just deferring it. When you turn 71, you can no longer have an RRSP. You can either withdraw all of your money, use the monty to buy an annuity, or convert it into what’s known as a Registered Retirement Income Fund (RRIF). You must make withdrawals from your RRIF and pay tax on that income.
TFSAs work in reverse. Your contributions to a TFSA aren’t tax deductible, meaning that your taxable income isn’t reduced at all. However, once the money is in the TFSA, it can accumulate and be withdrawn tax-free.
Both RRSPs and TFSAs can be used for retirement savings. And if you have the ability to do so, it’s best to make the maximum contributions to both accounts.
That said, it’s important to recognize that while RRSPs should primarily be used for retirement savings, TFSAs can be used for more general savings. Say you’re saving up for a car. You could invest your money in a TFSA, and once you have enough to make a purchase, withdraw money from said TFSA. You wouldn’t have to pay tax on that withdrawal and you avoid having to get a car loan.
The Bottom Line
When saving for retirement, you’re probably wondering what to contribute to first, an RRSP, or TFSA. Long story short, it depends on whether you think you’ll earn less income in retirement than you currently earn today. If so (and the majority of people are in this boat), you’re probably better off contributing to an RRSP first. Alternatively, if you think you’ll be in a higher tax bracket in your golden years, it’s best to contribute to a TFSA.