When you are planning investments within your Registered Retirement Savings Plan (RRSP) this year, as well as completing any contributions that will help reduce your 2012 tax liability, don?t forget your Tax Free Savings Account (TFSA).
You have until March 1 to add to your 2012 tax-deductible RRSP contribution. The maximum allowable contribution is $22,970 for 2012. So while you are at it, you may want to start your 2013 contributions, which are limited to $23,820. Remember you can carry forward unused RRSP contributions for the years 1991-2012, so your 2012 deduction limit may be more than $22,970.
In the meantime, you?ll want to decide what to contribute to your Tax-Free Savings Account (TFSA). The annual TFSA contribution has risen for the first time this year to $5,500 from $5,000, reflecting an increased rate of inflation. And you can use any accumulated unused contribution room. So, if you have not yet contributed and were 18 years of age or older in 2009 when the accounts began, the total accumulated amount that can be put into one of these accounts is now $25,500.
Contributions to TFSAs are?made with after-tax dollars, so there are no taxes on withdrawals or on capital gains, dividends or interest earned in the account.
Maximize Both Accounts
In the ideal retirement planning situation, you will have both plans and maximize their distinct advantages. You?ll want to talk to your accountant about how much to invest in each of these registered accounts as well as what investments you want to hold in them. It is particularly important to consult with your adviser to develop a realistic plan of action.
The TFSA has proved to be a popular way to save, but there is evidence that people view the vehicle more as a savings account than an investment account. About one in five households have a TFSA, but the investments have been conservative.
Yet the investment choices are broad and include stocks, bonds, mutual funds and higher-yielding short term deposits. In fact, you can generally hold the same qualified investments in a TFSA as in an RRSP, with the exception of non-arm?s length entities, including those where you are a ?specified shareholder? or have an interest of 10 per cent or more together with a non-arm?s length individual.
The Role of Tax Brackets and Withdrawals
The decision on whether to contribute to a TFSA or an RRSP is fundamentally a question of your current income and what you expect to have as income in the future. Here are three possible scenarios to illustrate what happens if you invest in the accounts over 20 years at compounded growth of 4% and annual RRSP contributions of $20,000.
Unchanged Tax Bracket of 40%: You assume you will be in the same bracket in 20 years when you retire. This year the $20,000 contribution would lower your income tax liability by $8,000. If you do not make that contribution, you would have $12,000 ($20,000 current savings minus $8,000 in tax for not getting the deduction) to invest in a TFSA.
After 20 years, the TFSA would be valued at $26,293 and the RRSP would be valued at $43,822. It seems the RRSP is the better choice, but because TFSA withdrawals are not taxed, the end result is equal. If you are still in the 40% bracket when you retire, withdrawals from the RRSP are taxed at that rate. If you withdraw $43,822 from the RRSP you owe $17,528 in taxes. The net amount is equal to growth in the TFSA.
Tax Bracket drops to 20% from 40%: If your tax bracket is 20% when you retire in 20 years, here is what happens. Any withdrawal from your RRSP is subject to 20% tax. Withdrawing $43,822 from your RRSP would mean that the estimated tax would be $8,764 and the net amount of $35,058 would be higher than the TFSAs $26,293 balance. When your income tax rate is higher when you contribute to an RRSP and lower when you make withdrawals, that account is the better option.
Tax Bracket rises to 40% from 20%: In this third scenario, for the current year, the $20,000 contribution would reduce your income tax liability by $4,000. If you don?t contribute to an RRSP, you would have $16,000 ($20,000 current savings minus the $4,000 lost tax deduction for not making the RRSP contribution.
In 20 years, the TFSA would be valued at $35,058 and the RRSP at $43,822. Although the RRSP will be higher, so is your tax bracket. Remember that TFSA withdrawals are not taxable. So now that you are in the 40% tax bracket at retirement your withdrawals from the RRSP will be taxed at that rate. Withdrawing that same $43,822, the estimated tax would be $17,529 and the net amount of $26,293 would be lower than the TFSA amount of $35,058.
Speak to a Redwood Capital Management advisor to determine the best strategy for using each of these savings plans to achieve your financial goals.
Source: http://www.redwoodcapital.ca/rrsp-vs-tfsa-which-is-better/
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