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How Much Should I Contribute to My RRSP and TFSA?

Get to know your Canadian tax shelters.

Ian Tam, CFA 21 December, 2022 | 1:48AM
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Canada

As Canadians, we are no strangers to paying taxes. Though it may seem like we pay a lot of tax, this OECD report tell us that we Canadians actually pay less income tax than countries like Japan, Denmark and Norway, while we pay more income tax than the UK, Costa Rica, and the United States.

Regardless, it’s always a good idea to try and save on your taxes, or at least defer them. As a Canadian, here are your options:

1. The Tax-Free Savings Account (TFSA)

The TFSA is a true tax shelter. The amount you can pay into this account annually is capped, and it is the same amount for every Canadian over the age of 18. Here are the annual TFSA contribution limits since the time the account was introduced in 2009.

In concept, if you’re reading this today and you don’t already have a TFSA, you can currently shelter up to $88,000 of after-tax money in this type of account. The key point here is that you’ve already likely paid taxes on the amounts that you shelter, and the proceeds of the account can grow tax-free.

Mechanics of Withdrawals

The mechanics behind how the TFSA works is like a high watermark. You can pull out proceeds anytime without tax consequences and re-contribute proceeds back into the account in the following year up to the maximum value of the portfolio prior to withdrawal. This makes the TFSA particularly useful as an emergency fund.

2. Registered Retirement Savings Plan (RRSP)

RRSPs are a type of tax deferral mechanism, with the idea that your income in retirement will be much lower than your income during your working years. Hence, you contribute pre-tax dollars to an RRSP account, which will be taxed when you withdraw from your account in retirement.

The key is that you avoid paying tax initially since you’ll receive a tax credit/refund in the years you contribute, so that the effects of compounding are not stifled for your investments. When you eventually retire, you’ll need to pay the tax rate prevalent at the time based on your income (inclusive of the RRSP withdrawals).

Mechanics of Withdrawals

Technically speaking, you can withdraw money from your RRSP at any time, but doing so in a year where you had significant earned income makes little sense because you’ll be taxed on withdrawal amounts at a high marginal rate. However, when you retire or when you turn 71, your RRSP can be converted into a Registered Retirement Income Fund (RIFF), which automates withdrawals to support living expenses in retirement. It is at this point you would pay taxes, but assumingly at a much lower marginal tax rate given that you have far less earned income in retirement.

How Much Should You Invest in Your TFSA and RRSP?

Much like everything else in finance, how much you invest in each of these accounts depends on your personal financial situation. Having said this, here are 3 factors to consider:

  1. Timing: If you had particularly good income this year, investing in your RRSP is a useful way to reduce your tax burden in this year. If you however prefer to not get ‘dinged’ when you withdraw and would prefer to use after-tax dollars to contribute, then the TFSA is your path. Additionally, if you foresee needing the money back in the short/medium term, the TFSA might be a more reasonable choice since withdrawals and deposits (within above limits) can occur freely without tax effects. The exception on this is the first time Home Buyers Plan, which allows an RRSP account holder to withdraw up to $35,000 without tax consequence for the purchase of a first home. This amount must be paid back in 15 years. 
  2. Contribution Room: Depending on your income level, it’s very likely that you will run into the contribution limit for the TFSA before you hit the limit on the RRSP. Consider using both.
  3. Type of Investment: Both accounts can hold most plain-vanilla investments like stocks, bonds, mutual funds, and ETFs. In general, it’s best to hold income producing instruments (like dividend stocks and bonds) within the confines of a tax shelter, because these types of income are taxed higher than capital gains.
     

Additional Pro Tip: If you are after a dividend paying U.S.-domiciled company or ETF, current tax rules would make it advantageous for you to hold this in your RRSP, because U.S. stocks held in these accounts are not subject to the 15% dividend withholding tax. The same does not apply to TFSAs.

Should I Contribute to my RRSP/TFSA or Pay Off Debt?

“Juggling financial goals is something you’ll be doing throughout your entire life,” writes Morningstar’s Josh Charlson. He recommends, even it’s small, to make contributions to your RRSP so you can get a head start.

To help you balance these financial goals, have a plan for paying down your debt. After you figure out how much you owe, how much time you have, and what the interest rates are, consider trying out one of these methods:

  • Debt avalanche: Rank your debts based on the interest rate from highest to lowest, make minimum payments on all the debts, and throw extra cash at the highest interest-rate debt. Once you pay off the highest interest-rate debt, move onto the next highest one.
  • Debt snowball: List your debts from smallest to biggest, make minimum payments on all the debts, and throw the extra cash on the smallest balance. Once you pay that one off, move onto the next debt, and keep building up the snowball until everything is paid off.

Develop a plan that works best for you and your situation with these steps. Given the trajectory of interest rates, it’s best to try to reduce debt to avoid having to pay increasing interest costs.

Remember: You Have to Invest in These Accounts

Simply opening a TFSA or RRSP at the bank doesn’t do anything for you (that would be like buying a new pair of sneakers and then not wearing them). To maximize utility, you must invest in those accounts. For the super conservative type of investor, many financial institutions offer high interest savings accounts and GICs within the confines of an RRSP or TFSA (both investments are guaranteed by the bank), alongside stocks, bonds, and mutual funds/ETFs.

Though we Canadians are not privy to an open banking culture, we can still open retirement savings accounts at almost any financial institution in Canada without limit. Whatever is contributed to these accounts is counted against your contribution limits for the year. Also remember that there is a chance that your employer might be contributing to and RRSP or TFSA on your behalf – remember to consider these contributions when calculating how much you contribute on your own to avoid any charges. 

This article does not constitute financial advice. Investors are urged to conduct their own independent research before buying or selling any security.

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About Author

Ian Tam, CFA  Investment Specialist at Morningstar Canada. 

 

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