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When it comes to registered savings plans, Canadians have two popular options: Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs). Each has its advantages and drawbacks. But ultimately, there’s no debate. These plans are so spectacularly good for savers that you definitley should have at least one, and preferably both. Here’s how they work.
Basically, an RRSP lets you contribute 18% of “earned income” every year to a pre-set maximum. For 2021, the maximum contribution limit is set at $27,830. And the last day to make a contribution for the 2021 tax year is March 1, 2022. In addition, you can carry forward any unused contributions from 1991 on and use them as well.
With RRSPs, you get a tax deduction for your contribution for a given year. If that tax deduction results in a tax refund, you can leverage the refund by reinvesting it right back into your RRSP to keep that compound growth working for you.
Remember that your investments grow tax-free while inside your RRSP. You don’t pay tax until you withdraw funds from your RRSP at retirement, when you can choose to roll the funds over into a Registered Retirement Income Fund (RRIF) or an annuity. At that point, you pay tax on income from your RRIF at your full marginal rate, which is typically lower than it is in your peak earning years. You may also choose to take your RRSP funds entirely in cash at retirement, but that will likely push you into the top tax bracket, and you may well pay over half the proceeds in tax.
Almost any investment can be put into an RRSP. “Qualified investments” include, for example, cash and GICs, stocks, bonds, exchange-traded funds, mutual funds, options, annuities, mortgages, and even gold and silver. There’s a complete list of qualified investments on the CRA website.
Tax-Free Savings Accounts are a bit different. You can contribute up to a maximum $6,000 to a TFSA in 2021, and there’s no income or means test involved. There’s also no cutoff date – you can contribute any amount at any time you want through the year, as long as you don’t exceed the maximum in a given calendar year. You have to be over 18 and a have a valid Canadian Social Insurance Number.
In addition, as with RRSPs, unused contributions can be carried forward and added to the maximum contribution in a future year. However, unlike RRSPs, there’s no tax deduction for contributions. But income generated within the plan – whether interest, dividends, or capital gains – is completely tax-free, both within in the plan and when you withdraw from the plan. As with RRSPs, the benefits of the dividend tax credit, the 50% capital gains exemption, and capital losses are lost within a TFSA.
Like an RRSP, qualified investments include cash, stocks listed on designated exchanges, mutual funds and ETFs, bonds, GICs, and certain shares of small business corporations. Note, though, that shares traded “over-the-counter” on dealer networks or exchanges are not qualified TFSA investments.
“In kind” contributions of qualified investments are also allowed (for example, stocks transferred from a non-registered account). But any in-kind transfer will trigger a deemed disposition of the security at its fair market value, which will be considered as the amount of your contribution. If there’s a capital gain, you will have to take 50% of the gain into income for tax purposes. But if there’s a loss on the disposition, you cannot use it to offset other gains.
Overcontribution occurs frequently for those who use their TFSA like an ATM. This usually results in a confusing cycle of contributions and withdrawals in a calendar year, so that you could end up with what are called “excess amounts” in your TFSA – that is, contributions over and above the $6,000 annual limit for the year.
And that overcontribution will attract a tax penalty of 1% per month based on the highest excess TFSA amount in your account for each month in which an excess exists. This means that the 1% tax applies for a particular month even if an excess amount was contributed and withdrawn later during the same month. The excess-amount tax kicks in on the first dollar of excess contributions.
If you’re trying to decide between one plan and the other, keep mind that an RRSP is commonly used for long-term retirement savings, allowing investments to grow and compound on a tax-deferred basis for 25 or 30 years or longer. TFSAs tend to be used for shorter-term savings goals over five to 10 years or so, for such things as a down payment on a home, a new car, or a vacations. They can also be used as an effective savings vehicle for education savings However, TFSAs are also useful after retirement for investing funds that are not required for income needs.
Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at rthompson@castlemarkwealth.com for a confidential planning consultation.
Notes and Disclaimer
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The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned are illustrative only and carry risk of loss. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.
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