When children get pocket money, they are advised to save some of it. It’s important to save at every stage of life, particularly during your working years. There are many ways you can save money. The simplest, of course, is to keep it in the bank. However, this may not be the best way to make your money grow. Not only do you have to consider interest rates offered by various financial institutions, you also have to think about taxes. Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs) both offer tax benefits and help your money grow. Let’s take a look at the key differences between them.
Deferring tax payments
You can reduce the amount you pay in taxes, but you can never avoid taxes completely. When it comes to RRSPs, contributions are typically tax-deductible, meaning that your RRSP contributions can reduce your taxable income in a given year. However, any money withdrawn from this account will be taxed according to your applicable tax bracket in the year of withdrawal. On the other hand, contributions to TFSAs are made with after-tax dollars, and withdrawals from TFSA’s are tax-free. In most cases, these accounts are used to provide a retirement fund. Once you’ve retired, your income is likely to be much lower than when you were working. Thus, your income tax rate will also likely be lower. For this reason, RRSPs are often considered more beneficial than TFSAs. However, if you will be receiving income from other sources that puts you in a higher tax bracket, TFSAs may be a better choice.
The RRSP contribution period
When it comes to an RRSP account, you can make contributions until the end of the year in which you turn 71. You will then need to convert it into income. However, there is no time limit for contributing to TFSAs. You also need to show earned income to contribute to an RRSP while you can contribute to a TFSA even without having an income. Therefore, TFSAs can be more flexible than RRSPs.
There are a few situations when RRSP withdrawals are not subject to tax, for example to buy your first home or use the money for higher education (if you meet the criteria). Otherwise, RRSP withdrawals are generally taxable. However all TFSA withdrawals are tax-free. Thus, dipping into your TFSA while you are still working has no impact on your income tax. For example, if you needed money in an emergency, dipping into your RRSP account during a year in which you had taxable income coming in from other sources would mean that you would have to pay an increased amount of income tax on your RRSP withdrawals. However, if you were to take this same amount out of your TFSA, it would make no difference to your taxes. If you withdraw money from your RRSP account, you will not get more contribution room as a result of the withdrawal. With a TFSA, withdrawals are added to the next year’s contribution room.
Whether you invest in TFSA or RRSP, you need to weigh the pros and cons carefully. Just because someone else invested in TFSAs instead of RRSPs does not mean that this is the best choice for you as well. The best thing to do when faced with such choices is to talk to a financial advisor.
This post contains sponsored links from Sun Life Financial.