People generally hate paying taxes. However, if you’re a taxpayer, you have to fulfill your tax obligations to the government. Fortunately for Canadians, there’s a savvy trick to boost savings and lower the amount of tax payable at the same time.
You can use the Tax-Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP) to perform the crafty move. Both are primarily investment accounts where you can save a generous amount or build retirement wealth. But you can utilize the two accounts to minimize the tax bite.
Begin with the TFSA
For younger taxpayers who are not yet in a position to max out the TFSA or RRSP, it would be best to save money in the TFSA. In all likelihood, you belong in the lower-income bracket, so the tax component is marginal.
Grow your TFSA balance
TFSA users usually purchase dividend stocks to place in the account. The returns are higher compared with other eligible investment instruments. Your balance will accumulate faster through the magic of compounding. BCE (TSX:BCE)(NYSE:BCE), a blue-chip company and Canada’s largest telco, is an excellent asset in a TFSA.
The 2020 pandemic emphasized the importance of connectivity. BCE and industry peers are charging at below cost, which jeopardizes future spending on high-quality networks. Thus, the Canadian Radio-Television and Telecommunications Commission (CRTC) might reverse its 2019 ruling to slash telecom rates.
You can purchase the telco stock to max out the TFSA contribution limit the Canada Revenue Agency (CRA) imposes every year. In 2020, the limit is $6,000, although the contribution room has been accumulating since 2009. To date, the maximum is $69,500. The CRA charges penalty when you make the mistake of over-contributing.
Since the telco stock pays a 5.82% dividend, your dividend income from a $6,000 investment is $349.20. In the TFSA, everything you will earn is tax-free. Thus, if your salary is lower than it would be in the future, focus on growing your TFSA and boost the RRSP later.
Swing from TFSA to RRSP
For income tax purposes, you can deduct your RRSP contribution from your earned income. But that is not the only tax advantage, because you can implement the savvy trick when your income brings you to a higher tax bracket.
If you have ample room in your RRSP and a substantial TFSA balance, withdraw from your TFSA. Swing or contribute the tax-free funds to your RRSP. You will get a larger tax refund with this move rather than prioritizing your RRSP over the TFSA.
Remember that you also grow your money tax-free in the RRSP, but it’s less flexible than the TFSA. Since RRSP withdrawals are fully taxable, you can hold off withdrawals until retirement. You’ll most likely be in a lower tax bracket by the time you’re ready to withdraw.
Wealth and taxes
Younger Canadians prefer using the TFSA, because you can withdraw money anytime without tax consequences. But if you hate taxes and want to pay less, involve the RRSP in your tax strategy. Throughout all stages of your career, you can effectively build wealth and reduce taxes by using the TFSA and RRSP.
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Fool contributor Christopher Liew has no position in any of the stocks mentioned.