The Motley Fool

RRSP vs TFSA: Which Is Right for You?

Tax efficiency is one of the most overlooked aspects of investing. Every dollar you earn on a trade has capital gains tax applied to it, and if you’re investing in dividend stocks, those payouts are taxed too. Currently, half of your capital gains are taxed at your marginal tax rate, while dividends are taxed anywhere from 25% to 47% based on a number of factors. So when you invest money, it pays to consider the tax consequences–and minimize them as much as you can.

Two of the most popular instruments for minimizing taxes are RRSPs and TFSAs. An RRSP is a retirement account that provides several tax benefits, but also some potential drawbacks. A TFSA is a savings account that exempts holdings from the usual dividend and capital gains taxes. Deciding which one you’ll put your assets in is one of the biggest financial decisions you’ll ever make. In this article, I’ll be reviewing the benefits of each while providing investing strategies appropriate for either one.

Tax benefits

RRSPs and TFSAs both provide considerable tax benefits. In the case of RRSPs, your holdings are tax deferred for as long as they remain in the RRSP account. While TFSA holdings aren’t taxed, even when they’re withdrawn.

RRSP holdings may be taxed as income when you withdraw them to a RRIF at the age of 71; the idea is that you will be retired by then, so the overall tax rate will be lower than it would otherwise be. However, if you never withdraw more than the minimum ‘lump sum’ amount from a RRIF, the income is not taxed.

If you want to withdraw money from an RRSP while you’re still earning income from a job, the tax consequences are negative: the withdrawal will be treated as income and taxed at your marginal rate. For this reason, if you’re going to invest in an RRSP, you should be committed to holding until either age 71 (when holdings are transferred to a RRIF) or when you’re not earning taxable income.

TFSA tax rules are simpler: the holdings are not subject to capital gains or dividend taxes when they are in the account, nor when they are withdrawn.

Long-term vs. short-term investing

Because RRSPs only have tax benefits if you hold to retirement, it’s to your advantage when using them to invest long term. Remember, if you withdraw early, you’ll be taxed as if the withdrawal was income, so this is not the place to pocket quick gains that you may be tempted to spend immediately. Good RRSP picks include long-term dividend stocks like Fortis Inc (TSX:FTS)(NYSE:FTS) that can be relied on to generate income for decades, and index funds like the iShares S&P/TSX 60 Index (TSX:XIU), which give you the average market return and the lower risk that comes with that.

With a TFSA, short-term trading makes more sense. Because you can withdraw from a TFSA at any time, you may enjoy the proceeds of high-risk/high-return trading in one if you wish. A stock like Shopify Inc (TSX:SHOP)(NYSE:SHOP) may be a good choice for a TFSA: it comes with a level of risk/volatility that’s not appropriate for retirement accounts, but also the potential for high returns that can be tax-exempted by trading it in a TFSA.

Our #1 Stock to Buy in 2019 (and Beyond!)

When you buy heavily cyclical stocks at low prices… and then hold the shares until the cycle reaches its peak… you can make a very healthy profit.

Every investor knows that. But many struggle to identify the best opportunities.

Except The Motley Fool may have a plan to solve that problem! Our in-house analyst team has poured thousands of hours into their proprietary research – and this is the result.

Our top advisor Iain Butler has just identified his #1 stock to buy in 2019 (and beyond).

The last time this stock went from the low point of its cycle to the peak… shares shot from $12 to $40 inside of 4 years. That’s an 300%-plus return. And if you missed out on that ride, today might just be your second chance.

Click here to claim Iain’s new report, absolutely FREE!

Fool contributor Andrew Button has no position in any of the stocks mentioned. Tom Gardner owns shares of Shopify. The Motley Fool owns shares of Shopify and Shopify. Shopify is a recommendation of Stock Advisor Canada.

I consent to receiving information from The Motley Fool via email, direct mail, and occasional special offer phone calls. I understand I can unsubscribe from these updates at any time. Please read the Privacy Statement and Terms of Service for more information.