(Ok, last dry and boring post. There will be more fun in the next series ?)
Lots has changed in the short period of time since I started learning about and contributing to RRSPs. One major change came with the Tax-Free Savings Account TFSA (which is probably the best retirement savings mechanism for low earners). What exactly does this mean to a newcomer? As mentioned in the previous money post, one pays taxes on almost all forms of income (wages, bank interest, rental income, etc.). The tax rate again depends on the tax bracket you are in.
Both RRSP (Registered Retirement Savings Plan) and TFSA (Tax-Free Savings Account) are investment saving accounts. You can invest the money in these two types of accounts in the same ways (GIC (Guaranteed Investment Certificate), company shares, bonds, mutual funds, you name it). But carefully read the names of the two savings vehicles: there is no retirement mentioned in the TFSA. And there is no tax-free in the RRSP. As discussed in the previous post, RRSP is a tax-deferral mechanism, i.e. “pay me later”. It is meant to stimulate your thinking about future retirement, by providing a tax relief on the amount you put into your RRSP account today (you don’t pay taxes on this amount today).
TFSA on the other hand is from after-tax money. You can put $5,500 (as of time of writing) each year in this account, as in other saving accounts. The $5,500 per year is your contribution room for this year (added to any unused contribution room from previous years), as is the 18% for RRSPs in the previous post (capped at $26,230 for 2018 – again in addition to previously unused contribution room).
However, there are some other differences:
a. Withdrawals and contribution room
RRSP: If you need the money and take it out of an RRSP (as in our example of year 3 for Sam in the previous post), that money can never be re-contributed.
TFSA: If you have money in TSFA and withdraw $10K, it gets added to your next year’s contribution room of $5,500. The total contribution room is based on number of years since 2009 when this investment saving tool was introduced. It is made available annually from January 1. The caveat is that if you withdraw in this year you have to wait until next year for it to be added back to your contribution room.
b. Withdrawals and taxes
RRSP: And as we saw in the previous post, Sam had to pay taxes on his RRSP withdrawal.
TFSA: Since your TFSA contributions are made with money that’s already been taxed (“pay me now”), your withdrawals are not taxed again.
c. Growth and taxes
This is another interesting aspect.
RRSP: All the money you gain during the years you saved and invested will be taxed later at withdrawal time. This means that if your $10K grew to $40K the $30K growth portion is taxed too.
TFSA: It is named tax-free, right? So, if you put $10K (again this is from your after-tax money) there and it grew to $40K with time, when taken out of this account you don’t pay taxes either on the $10K, or on the $30K growth.
d. End of contribution
RRSP: The name has retirement in it, right? It’s meant to be used as a tool to save for retirement while you are working and earning. You put some of your taxable earnings into an RRSP for use when you are retired. But your contributing years are cut off when you reach a specified age. Any remaining contribution room is then lost.
TFSA: In this case it really doesn’t matter where the money came from. As a matter of fact, millennials, if your parents gave you money you can stash some of it away in your TFSA. You don’t have to work for it. And contribution room continues to grow until you die ( or until some future government changes the rules or stops it altogether).
So, why is TFSA better for the low-income earners. All other things being equal, simply because it gives you the flexibility to use the money when you need it without losing your contribution room, and without the RRSPs potential side effect of bumping you into a higher tax bracket when you make a big withdrawal.
If you aren’t bored to death with this topic, I’d suggest that you read Shannon Lee Simmons’s great article in the Globe and Mail . She does a much better job of explaining this.
OK, I’m done with money. Lets move on to something more interesting.
Join the conversation around our e-Table