With each new year, every Canadian adult who earned income in the last year and is under the age of 71 gets additional room to contribute to their TFSA and RRSP.
Unfortunately, many Canadians remain confused about how both of these programs work. I thought it would be a good idea to give you the highlights of each program and outline your options for this year.
1) Tax-Free Savings Accounts (TFSAs)
In many ways, the TFSA is still poorly understood. I believe this is, in part, because the program was poorly named. The “savings” part of the name implies that TFSAs should be used as a high-powered bank account, and they surely can be. However, for many people, TFSAs are better used as a long-term investment vehicle in which you won’t pay any taxes on income or growth. Here’s what you need to know:
- Your annual contribution room for 2014 is $5,500. This is up from $5,000 in previous years. Your contribution room isn't dependent on income. You need only be 18 to start acquiring contribution room.
- Your total contribution room since the start of the TFSA program is $46,500. If you haven’t contributed yet, this is the maximum you can put in.
- You can make a contribution in cash or via an “in-kind” transfer of securities from any non-registered investment account you might have. Be aware of any possible tax implications when transferring securities, though!
- Unlike RRSPs, TFSA contributions don’t give you a tax deduction. However, you don’t pay tax on any growth in your TFSA account, or on any withdrawals.
- If you remove funds from your TFSA, you can re-contribute them in the following year. The exact amount you can re-contribute is based on the market value of the withdrawal, as opposed to the original contribution room!
- If you over-contribute to your TFSA, you will be liable for a 1% tax on your highest excess amount in that month.
2) Registered Retirement Savings Plans (RRSPs)
The RRSP is one of the best incentives the government has given us to help accumulate wealth and take care of ourselves in retirement. RRSPs have been around a lot longer than TFSAs, so they may be better understood. Still, here are some highlights:
- Your new contribution room for 2014 is based on 18% of your 2013 earned income, up to a maximum of $24,270. This room is reduced by any contributions made to a pension plan that you may be enrolled in through work.
- You may also use any additional "carry forward" room from previous years. This can be found on your Notice of Assessment from your 2012 tax return.
- Your RRSP contributions are tax deductible. They’re treated as a reduction in income. For many people, this tends to be one of the biggest incentives to contribute.
- You don’t pay any taxes on the growth of RRSPs until you withdraw funds from the plan. When you do, any withdrawals are counted as an increase in income for tax purposes.
- When you turn 71, you have one of the following three choices:
- Take the funds out of your RRSP in one lump sum. This is usually a poor choice given the large tax consequences!
- Transfer the funds into a RRIF (Registered Retirement Income Fund).
- Purchase an annuity.
TFSAs vs. RRSPs
Because RRSPs offer such great tax incentives, many people (almost blindly) put as much money as they can into their RRSPs for the sole purpose of saving money on their taxes. They may not realize, however, that they can be penalized from a tax perspective when they retire. Depending on your personal situation, there will be ideal times to use either a TFSA or RRSP, or both.
Business owners, on the other hand, may be best served by making no to minimal RRSP contributions. Instead, they may want to use their corporations as their wealth creating vehicles, given the ability to income split with their corporation in the future.
As an individual or a business owner, discuss all of your options with a trusted advisor to determine the best strategy to help you achieve your personal and financial goals!