Canadians can build tax-efficient wealth through the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA). The federal government introduced both to motivate people to save and invest, including a way to secure your financial future. Both investment accounts offer immense tax benefits, though treatment is different.
Now, which account is better depends on your income level. Your marginal tax rate is a key consideration here if you want to come out on top. While you can open an RRSP and TFSA, play it smart with strategic moves to maximize tax savings and avoid a big tax hit in retirement.
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The fundamental rule
RRSP contributions are tax-deductible, while withdrawals are taxed as regular income. TFSA contributions are not taxable and withdrawals have no tax consequences. Given these key features, prioritizing an RRSP or a TFSA follows a fundamental rule: your current marginal tax rate versus your likely marginal tax rate in retirement.
RRSP holders realize higher tax deductions during peak earning years when the marginal tax rate is highest. Later, in retirement or after full-time employment, you draw down funds and pay at a lower tax bracket.
TFSA users don’t get tax breaks from their contributions, but win through tax-free growth and tax-free withdrawals. If the immediate RRSP tax deduction gives you a low tax refund, prioritize the TFSA.
Quick reminders
High earnings in the middle-to-high income brackets today mean bigger tax relief when you make RRSP contributions. In retirement, your total income drops and lands you in a much lower tax bracket.
Your marginal tax rate is much lower early in your career but will rise over the next 5 to 10 years as your income grows. You can max out your TFSA today and let your money compound right away. Meanwhile, save your RRSP contribution room for your peak earning years to fortify your tax shield.
Finally, the RRSP was designed for long-term retirement savings. You pay withholding taxes upfront if you withdraw money early. The TFSA is your best option if you need funds for major purchases or to meet short- and long-term financial goals.
Put your RRSP and TFSA to work.
The RRSP and TFSA have identical, eligible investments. You can hold bonds, guaranteed investment certificates (GICs), mutual funds, real estate investment trusts (REITs), exchange-traded funds (ETFs), and Canadian domestic stocks in either account. Only the RRSP accepts foreign investments, such as U.S. dividend stocks, and grants foreign withholding tax exemptions under a tax treaty.
Fortis (TSX: FTS), a TSX dividend king, is a suitable investment for both the short and long game, until retirement and beyond. The $38.4 billion regulated electric and gas utility company has increased its dividend for 52 consecutive years. Its low-risk profile stems from essential, rate-regulated utility operations that generate stable cash flows.
At $77.94 per share, the annual dividend yield is 3.3%, paid quarterly. A $25,000 investment today will compound to $48,616 in 20 years, including dividend reinvestment. The entire amount is taxable when you pull it out from the RRSP later. The same amount will produce $208.13 in tax-free income every quarter in your TFSA, and it can last for life.
Know the distinction
Choosing between an RRSP and a TFSA isn’t a contest but a strategic, advantageous decision. By understanding the tax treatment of both accounts, you can place your money where it belongs.
