Q: For people who don't know how to choose between putting their money into an RRSP or a tax-free savings account, what factors do you think people should consider before making their decision?
Judith Cane responds:
I would not replace an RRSP contribution with a tax-free savings account, because the difference is while you can take the growth of the money out of your tax-free savings account, you do get a credit on your income tax if you make an RRSP contribution. I always recommend that people max out their RRSP contribution, if they have any money left over then that's when they should be putting into the tax-free savings account.
It's a $5,000 maximum that should be used for short-term savings goals. If you want to buy a car or you're saving for a down payment for a house or you even want to buy something as small as a big-screen TV, it's a good way to save money and not pay tax on the growth of that money. And it also gives you carry-forward room next year.
We're in Ottawa, so it's a big government town, and lots of people have pensions — or if you're working with teachers, they all have pensions — they're really limited as to how much they can put into RRSPs. For people like that who don't have a lot of room in their RRSPs but want to save money for their retirement, they could put it into a tax-free savings account, and that money would grow tax-free similar to an RRSP.
Sandra Foster responds:
The tax-free savings account is one of the newest tax vehicles for Canadians that we've seen in a long time. For those who don't have corporations, who don't have any fancy ways of doing anything, for people who say, "I'm just an employee there's nothing for me out there, there are no ways for me to save tax" — here's one.
'For those who don't have corporations, who don't have any fancy ways of doing anything, for people who say, 'I'm just an employee there's nothing for me out there, there are no ways for me to save tax' — here's one.'— Sandra Foster, financial adviser
Sometimes people don't want to use the RRSP because they're in a low tax bracket now, they'll be in a low tax bracket when they retire so they really don't get much tax savings from using an RRSP. The RRSP could be large, so taking the money out is according to a government schedule. They don't have control over the amount that comes out, so starting to put some money into a tax-free account allows them some control over the money.
If you're over 71 and you don't have any more earned income [or] if you've got any savings outside your RRSP (emergency savings, a few investments, you're saving up for a house or a car) — it means any interest that you earn on money up to $5,000 this year, you don't have to pay tax on that interest. Next year, it'll be any interest you earn on $10,000 plus a little bit for inflation.
If you have money in an account, just in a savings account that you're saying this money is earmarked for my next car, you're going to have to pay tax on that interest. But if you say this money in my tax-free savings account is earmarked for my next car, you can take that money out when you're ready to buy the car, not pay tax on the interest and put the money back in because you don't lose your room. With an RRSP you lose your room, and you have to pay tax on the money when you take it out. If the RRSP will give them enough of a tax benefit, I would recommend that they [also do a TFSA] if they've got the money.
There are people today that aren't sure that they will still have their job in May, so they might want to do their tax-free savings account first, because they don't know what their tax bracket is going to be. They might want to do their monthly savings into their tax-free account until they hit $5,000 before they divert their monthly savings into their RRSP — just because there are people losing their jobs right now.
John Kason responds:
For a professional who is 10 to 15 years before retirement with an income of about $100,000, I would do an RRSP and use the tax return as the proceeds to fund the tax-free savings account. [I would do that] simply because I am in effect double-dipping. I'm funding further savings with government money so I'm investing more at the end of the day.
But if a person's very close to retirement — if they're going to retire in the next two to five years — I would fund the tax-free savings account instead of the RRSP. I believe the flexibility is going to provide people with a greater benefit.
If you're close to retirement, it doesn't make a whole lot more sense to keep funding your RRSP because you're going to start withdrawing [soon]. The tax-free savings account is going to potentially give you a source of tax-free income but also capital, which in my experience is always needed in the early years of retirement. If you're close to retirement, I think a person should skip the RRSPs and start aggressively funding the tax-free savings account. Continually funding the TFSA is important — just putting $5,000 in it and thinking all your problems are solved, that's not going to work.
If you're a young person, under 40, I think a tax-free savings account has more application. The flexibility of being able to access the capital and the income for a young family gives a person more options to accessing the capital. It can be just a basic savings account, you don't have to invest it in anything particular but when you need the capital, you don't get hit with the tax withdrawal. If you take it out of the RRSP, you're going to get taxed.
'The first year, it's not going to make a hill of beans, but once you've done this for couple years in a row, there could potentially be quite a bit of money there.' —John Kason, certified financial planner
The tax-free savings account gives people wider options. I'm not a huge advocate of RRSP accounts to medium- to low-income earners. High-income earners, yes, it makes sense especially if you don't have a pension. You're able to dip into it if you're investing it, the income may be able to subsidize your lifestyle or subsidize further investing.
If you have $10,000 in your tax-free savings account and it goes up 10 per cent, that $1000 could then be used to make an RRSP contribution or it could be used to make an RESP contribution it could be used to spend on reducing debt or going on a holiday. There's no negative to taking that money out versus once it's in an RRSP — it's quite long-term.
The first year, it's not going to make a hill of beans, but once you've done this for couple years in a row, there could potentially be quite a bit of money there.