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.
As an income-earning Canadian adult, there are two investment vehicles you should consider taking advantage of (if you aren’t already) to reduce your tax bill.
The first vehicle, an RRSP, allows you to contribute a portion of your income to a registered investment account. In doing so, your taxable income is reduced, while your contribution/investment grows tax-free.
On the other hand, a TFSA does not affect your earned income, but it does allow you to contribute and invest a stipulated amount each year, which will grow tax-free.
Unfortunately, many Canadians are confused about how these programs work. For that reason, I thought I’d highlight how each program works and outline your options.
Tax-Free Savings Accounts (TFSAs)
One of the reasons TFSAs are not well understood is their name. It was poorly labelled. The word “savings” implies they are best used like a bank account. Although they surely can be, TFSAs are most effective as long-term investment vehicles. Being completely tax-free allows an investor to grow their portfolio without being required to pay taxes on the profits. Here’s what you need to know:
- Like I mentioned above, the most attractive feature of a TFSA is that investments held within this type of account can grow tax free.
- Unlike with an RRSP, TFSA contributions do not provide a tax deduction to your income. But on the other hand, there are also no tax implications when withdrawing funds from a TFSA, making this a much more flexible vehicle.
- Your annual contribution room for 2020 is $6,000. Your contribution room isn't dependent on your income. You need only be 18 to start acquiring contribution room.
- As of 2020, resident taxpayers (age 18 or older in 2009) will have accrued $69,500 of TFSA contribution room. If you have yet to use a TFSA, this is the maximum you can contribute.
- You can make a contribution in cash, or via an “in-kind” transfer of securities from any non-registered investment Be aware there may be tax implications when transferring securities from a non-registered account with unrealized capital gains!
- If you remove funds from your TFSA, they can be re-contributed the following year. The re-contribution room is based on the market value of the funds when they are withdrawn - not the amount of the original contribution! (Eg. An investor contributes $10,000 in 2017. This amount is invested and grows 10% by 2019 to $11,000. The investor withdraws $5,000 in 2019. In 2020, his contribution room will be $5,000 plus $6,500).
- If you over-contribute to your TFSA, there is a monthly 1% fine on the excess contribution. This is applied every month your account remains over the allotted amount. The government has aggressively pursued this penalty.
- If you are unsure about your TFSA contribution room, the most reliable way to find out is through the MyCRA
Registered Retirement Savings Plans (RRSPs)
The RRSP is one of the best incentives we have to help accumulate wealth and provide for our retirement. RRSPs have been around much longer than TFSAs, so they may be better understood. However, a short review may be helpful:
- Your new contribution room for the 2019 tax year is 18% of the income you earned in 2018, up to a maximum of $27,230. This room is reduced by any contributions made to a pension plan through an employer.
- You may also use any unused (carry-forward) room from previous years. This amount can be found on your Notice of Assessment from your 2018 tax return.
- RRSP contributions are tax-deductible. They are treated as a reduction in income. For many, this is one of the biggest incentives to contribute.
- The growth of investments inside an RRSP are not taxed until they are withdrawn from the plan. When that occurs, all withdrawals (with the exception of funds used to purchase a first home, or for education) are counted as income for tax purposes. Since the purpose of this account is to fund retirement, the assumption is that most will be earning less when they withdraw from their RRSP, thus having a much lower tax impact.
- When you turn 71, you have one of the following three choices:
- Withdraw funds from your RRSP in one lump sum. 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 effective and instant tax incentives, many people (almost blindly) contribute the maximum allowed into their RRSPs. When they retire, however, this could prove punitive from a tax perspective. Depending on your personal situation, there are times when it is best to use a TFSA, an RRSP, or both.
Business owners, on the other hand, may be best served by not making RRSP contributions. Depending on their situation, investing through their corporations may be more effective. It’s important to understand your options and how they work.
As with most tools, there are times when one is more appropriate for the job than another. For this reason, you may want to discuss your situation with a trusted advisor to determine the best strategy to achieve your personal and financial goals!