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While you consider how much you will contribute to your Registered Retirement Savings Plan each year, also think about how you could split your savings between your RRSP and a Tax Free Savings Account (TFSA).
You will want to consult with your accountant on the best way to apportion your money, but meantime here is a refresher on how both accounts can work to your advantage.
Every Canadian age who reaches the legal age of majority, which depends on the province, and holds a valid Social Insurance Number accumulates TFSA contribution room each year, indexed to inflation. In the year you reach majority you can deposit the full contribution amount for that year regardless of the month of your birthday. The accounts can be opened through banks, credit unions, insurance companies or trust companies.
Canadians living abroad may contribute to a TFSA provided that they still have residential ties in Canada. If your status changes to a non-resident with no residential ties you are still allowed to keep your current TFSA, but no further contribution room will accumulate while you remain a non-resident.
Deciding whether to contribute to an RRSP or a TFSA is a question that you may face every year. The answer depends on the specifics of your financial circumstances.
If you are a lower-income earner such as a student or starting level employee, a TFSA can be a good choice. Your RRSP deduction will not save you as much tax today as it could in the future when you are in a higher marginal tax rate bracket and it will help lower your taxes.
If you are a senior, a TFSA offers you ability to reduce taxable income. You can contribute to an RRSP only until the year you turn 71. Before the end of that year you must convert the plan to a Registered Retirement Income Fund RRIF) or an annuity. A TFSA withdrawal will not impact benefits such as Old Age Security, the Guaranteed Income Supplement, child tax benefits, or GST credits. An RRSP withdrawal could generate a clawback of these benefits.
As a senior, you may not need the funds in the future and you may not want to withdraw the money immediately. This is possible with a TFSA whereas a RRSP requires you to start withdrawals at the end of the year that you turn 71.
Generally, you should contribute to your RRSP during your working years because it provides you with a deduction to income at your highest earning years. It is also a good tool to help you save, as there are the tax consequences if you decide to withdraw the funds.
The savings accounts can provide a major boost toward reachingotherfinancial goals without being locked into tax consequences for early withdrawals. Non-retirement financial goals such as saving for a vacation, car, or home are all reasons to contribute to a TFSA.
Among the advantages of TFSAs is that any income, interest, dividends, and/or capital gains in the account are earned tax-free. Unused TFSA contribution room is carried over to the next year. The accounts provide many investment options to choose from, including mutual funds; Guaranteed Investment Certificates (GICs); stocks; certain mortgages and bonds.
You may also open a self-directed TFSA that lets you manage your own portfolio. If you opt to take this route, you must be aware of non-qualified or prohibited investments in order to avoid unexpected taxes. A prohibited investment is an investment in debt of the TFSA holder or an investment in which the TFSA holder has a significant interest. In other words you cannot include shares of your own company, a company in which you have a significant interest, or any investment where the TFSA does not deal at arm’s length.
Where a trust that is governed by a TFSA holds a prohibited investment during the calendar year, the holder of the TFSA is liable to pay two taxes:
| 1. A one-time tax when a prohibited investment is acquired or when a previously acquired property becomes a prohibited investment. The tax is equal to 50 per cent of the fair market value of the property when it was acquired or became prohibited. If the prohibited investment ceases to be a prohibited investment while it is held by the trust, the trust is considered to have disposed of and immediately re-acquired the property at its fair market value.
2. Income (including capital gains) on prohibited investments – 100% tax under the “advantage” rules. |
All TFSA withdrawals are tax free and the full amount of withdrawals can be re-deposited in future years. Withdrawing funds from your TFSA increases your contribution room for future years but not for the year of the withdrawal.
If you plan to make a withdrawal, it might be best to do it before December 31. That way you could pay it back into the plan in the next year. providing even more contribution room for next year. If you wait until January or later to make the withdrawal, you must wait a full year before re-depositing the money.
It is crucial to note that depositing large amounts in the same year that you withdraw from your TFSA may exceed your current year’s contribution limit and subject you to penalties. The penalty is one per cent of the highest amount of over-contribution in the month and will repeat each month you exceed the limit.
Income generated and withdrawals taken from a TFSA do not affect the income requirements to be eligible for benefits of Old Age Security, Child Tax Benefits, relief from medical premiums, and other federal benefits determined by income. This provides an opportunity for seniors and Canadians with low to moderate income to earn investment income while still retaining their benefits.
You may transfer funds to a spouse with no tax consequences if the funds are invested into a TFSA. In case of the death of a TFSA holder, the account generally can be transferred to a spouse or common-law partner who is appointed successor holder without tax consequences or impact on the successor’s existing contribution room. There may be some tax consequences incurred on income earned within a TFSA after the date of death of an account holder.
If you are looking for a way to save money, invest for the short term or long term and not be subject to the high restrictions of an RRSP, a TFSA may be your best choice. Consult with your accountant for guidance on which account best suits your situation.
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