TFSA versus RRSP
The Tax Free Savings Account, TFSA, was introduced in 2009. The current contribution limit for both 2009 and 2010 is $5,000. If you don’t use it, you don’t lose it i.e. the limits are cumulative. Therefore, if you are age 18 or over in 2009, you now have $10,000 of TFSA room. The question becomes, what’s the best strategy to use going forward? Should you put money in an RRSP or a TFSA or both?
Here is a quick review of TFSA versus RRSP. The TFSA does not generate a tax credit but any income, dividends or capital gains earned inside the TFSA are not subject to tax when withdrawn. With an RRSP you receive a tax credit each year for contributions made based upon your marginal tax rate (see table below for examples). But the RRSP is a tax-deferral mechanism and down the road when you make withdrawals, the RRSP will be subject to tax as ordinary income i.e. fully taxable.
While you have the option to contribute to either or both the RRSP and/or TFSA, you may want to consider your marginal tax rate. The marginal tax rate is the amount of tax you pay on the last dollar earned. If we look at the three examples below, you will notice that the tax system is progressive i.e. the higher the taxable income, the higher the tax paid on the next dollar earned.
* assuming only the basic personal tax credit is claimed. Source (Manulife Investments: 2010 Advisor’s Quick reference Guide).
If you expect your retirement income to be roughly the same as during your retirement years, the TFSA may make sense. The RRSP only defers tax until you make withdrawals in retirement.
If you expect your taxable income in retirement to be lower than your working years, then the RRSP may make more sense. Assume that your taxable income were $60,000 in your working years but $30,000 in your retirement years. Contributions to the RRSP get a 21% tax credit now but upon retirement withdrawals would only be taxed at 14.1%.
For 2010, the RRSP contribution limit is 18% of earned income or $22,000. This equates to an earned income of $122,222. The annual TFSA room is $5,000.
In the end, it all comes down to having a plan and executing a strategy that makes sense for you. TFSAs will play a larger and larger role in the retirement planning for Canadian over the years. Have you developed a TFSA strategy with your advisor? Do you have a financial plan?
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