An RRSP contribution is most tax advantageous if made during your highest earning years and withdrawn in your lowest earning years. Otherwise a TFSA may provide the better investment vehicle from a tax perspective.
Registered Retirement Savings Plans (RRSPs) offer an immediate and potentially a long term tax break. To understand this, recall that Canada has a progressive tax rate – as you move to higher tax brackets, you pay a higher rate of tax. A contribution to your RRSP is an immediate deduction to your income – and the deduction starts at your highest tax bracket. Withdrawals from your RRSP are added back to your income in the year withdrawn – increasing your income in that year.
You can contribute up to 18% of your earned income from the previous year to a maximum of $26,230. The contribution limits are cumulative and carried forward indefinitely. Your CRA notice of assessment will detail the total contribution limit available. Note Over contribution penalties are 1% per month.
To attain the most tax effective RRSP – invest into the plan when your income is at its highest during your earning years and make withdrawals when your income is at its lowest. This can be done by looking at overall anticipated income levels and making estimates over a period of time.
Changes in tax rates will affect your tax savings. As such, the timing of your RRSP investment is important, especially in years there are changes at either he provincial or federal tax rates. An investment in January or February this year can be deducted in either your 2018 or 2019 on your personal return.
Consider if you were in the top tax bracket in 2014 – you would have saved 39% for your contributions, in 2015 that rate went up to 40.25% and for 2016 that will be 48%. So if you were in the top tax bracket – a contribution to your RRSP in 2016 rather than 2015 would save you close to 8% in tax you would otherwise pay.
However, not all tax rates are go up… the higher income rates increased in those years – however, if you were in the $45,000 to $90,000 income range – those rates decreased by 1.5% between 2015 and 2016. So if your earnings were in that range you would want to have made your contribution in 2015 to save that 1.5%.
Making a contribution in January of February allows time to calculate what year you wish to make that deduction.
Tax free savings accounts were introduced in 2009 and allowed contributions of $5,000 annually for years 2009 through 2012 and $5,500 for years 2013 and 2014 and $10,000 for 2015 – returning to a contribution limit of $5,500 for 2016, 2017 and 2018 and $6,000 for 2019. The maximum contributions for all years up to 2019 total $63,500 per individual over the age of 18.
Contributions are not tax deductible. However, you will not pay any tax on income or gains from your TFSA account or on withdrawals from this account. Withdrawals from your TFSA will also not be considered for income tested eligibility such as OAS claw backs – and withdrawals can be recontributed in subsequent years.
When selecting your investment in a TFSA – you likely do not want your TFSA to hold investments that hold foreign dividend type of income – withholding tax is paid on investments held in TFSAs (and RESPs) – and you cannot claim an offsetting foreign tax credit because you pay no Canadian tax on TFSAs (or RESPs). Effective investments for tax purposes within your TFSA would include Canadian interest generating income (although these are not necessarily investments that net you the most return).
Consider investing in a TFSA for tax deferred growth when you are in a lower tax bracket. This will preserve your RRSP room for when you will get a higher tax deduction. The TFSA is also ideal if saving for a home or vehicle purchase – where the withdrawal may be made tax free regardless of if you are in a higher earning year.
This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action.