RRSP season: it’s an annual ritual. As the March 1 deadline to contribute to registered retirement savings plans approaches, Canadians are inundated with advice – both solicited and unsolicited – about the need for saving. More specifically, how much to save and whether to put their money into an RRSP, a Tax-Free Savings Account (TFSA) or toward something else. How do you navigate all the choices and opinions? Njideka Harris-Eze, a Calgary-based financial consultant and educator with T.E. Wealth, says it’s important to be wary of one-size-fits-all advice. “Finance is so personal,” she explains. “You can have two individuals with very similar lives and financial situations, but the right strategy might be completely different for each of them.”
This RRSP season could be different in its own way, too. One unforeseen impact of the COVID-19 pandemic has been that consumer savings rates have skyrocketed to historic highs, as spending has sharply declined and many Canadians have received government income assistance. At the same time, economic uncertainty remains high and the adverse economic effects of the pandemic might last for a while. That’s why, when trying to decide how to save, Harris-Eze urges clients to weigh all of the factors that affect their financial health now and those that could affect it in future.
“What works for you this year might not work next year,” she says. “You have to be flexible enough to adjust.”
The beauty of the RRSP/TFSA system, says Harris-Eze, is that it allows Canadians to make those adjustments, and put their savings towards the balance of short- and long-term goals that make sense for them. To do that, it’s important to understand the basic differences between the two vehicles and their relative advantages.
An RRSP allows savers to shelter savings and any investment gains from taxation, ideally until retirement when they can withdraw funds and pay tax at a lower rate because their income will (usually) be lower. For that reason, “the nature of an RRSP is that it’s for paying for a long-term project, such as retirement,” says Harris-Eze. On the other hand, a TFSA confers no tax-deferral advantages; the saver contributes after-tax dollars and cannot deduct them from reported income in the contribution year. However, any gains within the TFSA are not subject to taxation; nor are withdrawals, and withdrawing funds does not affect your contribution limit. For those reasons, a TFSA might be a better choice in a “transitory situation, where you might not be ready to commit those funds to longer-term plans,” says Harris-Eze.
How can these options be applied towards different goals? Let’s take two hypothetical Canadians with the same income, who each have $10,000 to save this RRSP season. Assuming their contribution limits allow, one might think they should both put the money into their RRSPs and get a step closer to their retirement goals. Yet that might not be the right choice. For instance, perhaps one of our hypothetical Canadians believes their job is not secure. A TFSA might be more appropriate, Harris-Eze says, because it would allow tax-free access to emergency funds. But maybe this same job-insecure person knows their company has a generous severance policy. They could choose to contribute to an RRSP because they are confident they won’t need an emergency reserve. “Or perhaps they have a partner who has a secure job – that changes the dynamic too,” Harris-Eze says.
She adds that there are a few general circumstances where a contribution to a TFSA might be preferable to an RRSP. For one, a TFSA is a simple option for people who have already maxed out their RRSP contribution limit. As well, a TFSA might be more appropriate for those with lower incomes, because they are in a lower tax bracket, so the tax deferral benefit of an RRSP might be small or negligible. For instance, a young person just starting out in their career could park savings in a TFSA, then transfer the funds to an RRSP as they earn more and move into a higher tax bracket.
A TFSA can play an important role in retirement, Harris-Eze says, because it can help retirees avoid income spikes when they need large sums of short-term cash.
Consider a retiree who lives in their own house and suddenly needs $50,000 to get the roof replaced. If all their savings are in an RRSP, they would have to withdraw $71,500 to get their $50,000 net of withholding taxes. That withdrawal would dramatically increase their taxable income for the year, which could mean Old Age Security benefits will be clawed back. They might also have to pay tax on the RRSP withdrawal beyond the withholding taxes. “But if you had money in a TFSA, you could withdraw the $50,000 – it’s not taxable income – and you have only earned your normal income for the year,” Harris-Eze explains. “In coming years, if you have surplus funds, you can return all or part of that money to the TFSA.”
Clearly, the benefit of the RRSP/TFSA system is that it creates optionality, allowing savers to adjust their strategies to their circumstances while helping them attain their goals.
Of course, to do that you need to have goals, and Harris-Eze emphasizes that sound retirement planning is essential. “If I have a retirement plan in place, it tells me what options I should be considering to reach my goals and will show me how I should grow my money,” she says. “It puts all of our decision-making in a place of logic.” Getting good advice, she adds, is invaluable. A financial advisor can help you create a plan for the long (and short) term, and help you understand and choose your savings options. “A good adviser,” Harris-Eze says, “really knows their clients and is bold enough to say what’s right for them – not just what may be popular out there in the market.”
When it comes to finances, there are as many unique situations as there are Canadians. “Whenever we take a one-size-fits-all approach,” Harris-Eze adds, “we usually find that it doesn’t work for most people.” In the end, there is no “right” choice between an RRSP and a TFSA – there is only the choice that is right for you.