RRSPs vs TFSAs: a credit advisor weighs in on the debate

Posted on by Duane Roberts

TFSA RRSP Retirement Personal Finance

Investments don’t have to be complicated, but if RRSPs are your only emergency fund, you’re getting ready for disaster

Publication date:

February 25, 2022 • February 25, 2022 • 4-minute reading time • Join the conversation Both TFSAs and RRSPs have annual contribution limits, but you get your TFSA contribution margin back in the year after any withdrawal. Both TFSAs and RRSPs have annual contribution limits, but you get your TFSA contribution margin back in the year after any withdrawal. Photo by Mike Faille/National Post artwork files

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While the deadline for contributing to your Registered Retirement Savings Plan (RRSP) for the 2021 tax year is just around the corner on March 1, it’s never too late to discuss the pros and cons of RRSPs.

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While they’ve gotten a bad rap in recent years due to the tax implications of early withdrawal, that doesn’t mean they can’t provide some benefits if used correctly.

The biggest advantage of an RRSP is the tax advantage you receive when making a contribution. Any contribution you make to an RRSP is tax deductible, which can result in a larger tax refund or a reduction in the amount of income tax you owe. Your goal for investing in RRSPs should be to save for retirement when your projected income and tax bracket will be lower.

The idea is to reduce the amount of income tax you now have to pay while you work. Then, when you retire and your income falls, you can withdraw your RRSP and pay taxes on withdrawals at your lower/retirement income level. People run into trouble when they pay out an RRSP early and end up owed that year for the previously deferred tax.

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Another benefit of investing in RRSPs is that a first-time home buyer under the Home Buyers’ Plan can borrow up to $35,000 from their RRSP to buy their first home. The government then gives them 15 years to repay the money to their RRSP. Any year in which they fail to repay 1/15 of what they have withdrawn, the unpaid amount is taxed as their last dollar earned. It’s important to budget carefully and contribute each year to what you’ve borrowed, but you should also declare it as a home buyer’s refund on your tax return.

Registered retirement savings can also come in handy if you or your spouse decides to return to school. Under the Lifelong Learning Plan (LLP), you can borrow up to $10,000 per calendar year from your RRSPs for full-time training or education, up to a maximum of $20,000 each time you participate in the LLP program. You may then need a maximum of 10 years to repay your loan. As with the Home Buyer Plan, every year you don’t repay it and designate it as such in your taxes (1/10 for LLP), you’re taxed on it as if it were income.

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Any amounts contributed to an RRSP that are more than 12 months old are protected in the event of bankruptcy. Not that anyone plans to become insolvent, but should you find yourself in dire straits, you don’t have to sacrifice future retirement savings to pay off current debt.

Investment portfolios grow tax-free as they are invested within the RRSP, and the rate-increasing effect becomes even greater over a longer time horizon.

Is it worth investing in an RRSP? Here’s the math

How do you decide between money in a TFSA or an RRSP?

FP Answers: Should I invest in a TFSA or RRSP? And when does it make sense to do both?

Some of the reasons why the RRSP has lost ground over the past generation are obvious.

The RRSP has fallen out of favor, but there are still plenty of good reasons to contribute

However, despite all the advantages of an RRSP, the disadvantages are worth keeping in mind. One of the biggest is how you view your RRSP: is it your emergency savings fund or is it money for your retirement? Withdrawing money from an RRSP during your working years to cover an emergency expense has significant tax implications. Every dollar you withdraw is added to that year’s income. That affects the amount of income tax you have to pay, as well as income-based government programs that you qualify for.

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To avoid having to use emergency RRSPs, diversify your savings. RRSPs are not intended to be short-term savings. Open a savings account or unregistered investment to get rid of emergency funds. There is no tax benefit on this money, but neither will you be penalized on your taxes for using the money to repair your car or buy a new water heater. And there is no credit card interest to be paid on these expenses because you have cash on those bills.

This is where a tax-free savings account (TFSA) can come in handy. TFSAs have, for good reason, been all the rage since their introduction in 2009. Contributions to a TFSA are made with after-tax income and grow tax-protected; you pay no income tax on the interest you earn. Any withdrawals are not taxed as income because you paid income tax on the money before it went to the TFSA. There is no tax deduction available for TFSA contributions as with RRSPs, but there is also no downside to using the money when it is needed.

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Both TFSAs and RRSPs have annual contribution limits, but you get your TFSA contribution margin back in the year after any withdrawal. For example, if you take $2,000 out of your TFSA to go on vacation this year, the $2,000 will be added to your annual membership limit next year. If you withdraw $2,000 from your RRSP this year, you will not be refunded the contribution margin in your RRSP and the amount withdrawn will count as income with a tax portion withheld at source.

Investments don’t have to be complicated, but if RRSPs are your only emergency fund, you’re setting yourself up for disaster. Seek advice from an investment professional who can help you determine which products best suit your short- and long-term financial goals.

Sandra Fry is a Winnipeg-based credit counselor at Credit Counseling Society, a nonprofit organization that has helped Canadians manage debt for more than 25 years.

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This post RRSPs vs TFSAs: a credit advisor weighs in on the debate

was original published at “https://financialpost.com/personal-finance/retirement/rrsp/rrsps-versus-tfsas-a-credit-counsellor-weighs-in-on-the-debate”

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