Contribution conundrum: How should you save for retirement?

Damien Burleigh, CFP®, CLU®

When it comes to saving for retirement, many investors wonder if they should contribute to an RRSP, TFSA, or perhaps some combination of both. Let's review some of the key details of RRSPs and TFSAs in general, and then take a closer look at some key factors to consider when making your own decision.

RRSP Overview

The Registered Retirement Savings Plan (RRSP) was established in 1957 and is a popular account type for Canadians saving toward retirement.

You can contribute up to 18% of your previous years' taxable income to your RRSP each year, subject to an annual maximum of $29,210 in 2022, rising to $30,780 in 2023. Unused contribution room can be carried forward to future years, and contributions can be made to an individual, group, or spousal RRSP. If you contribute more than $2,000 over the limit at any given time, a penalty of 1% per month is generally charged on the excess amount until withdrawn.

Contributions to an RRSP are tax-deductible, and deductions can be claimed in the current year or carried forward to be used in future years. Inside the RRSP, all investment returns – interest, dividends, and capital gains – are sheltered from taxation. Funds can be withdrawn from an RRSP at any time, however every dollar withdrawn is taxed as regular income and withdrawals do not regenerate contribution room. RRSPs mature in the year the account holder turns 71 and must be transferred to a RRIF, withdrawn as a taxable lump-sum, or used to purchase an annuity.

TFSA Overview

In 2009, the Canadian Government announced a new type of account that offers significant flexibility and tax advantages: the Tax-Free Savings Account (TFSA).

Canadian residents begin accruing TFSA contribution room at age 18 and can open and contribute to a TFSA account when they reach the age of majority in their province of residence. Canadians can contribute up to $6,000 per year (increasing to $6,500 in 2023) regardless of income, and unused contribution room carries forward indefinitely. When funds are withdrawn from a TFSA, contribution room equal to the amount withdrawn is made available again in the next calendar year. As of 2022, the total cumulative contribution amount for Canadians who were at least 18 years old in 2009 is $81,500.

While contributions to a TFSA are not tax deductible, investments inside the TFSA grow tax-free, and withdrawals from the TFSA are also tax-free. Many Canadians use TFSAs to save for retirement, although TFSAs can be used for any purpose, such as a down payment on a home, paying for education, or as an emergency fund.

Key Considerations: How to Decide

First and foremost, the decision around RRSP and TFSA contributions can be viewed as an "and" decision rather than an "or" decision. That is, you can contribute to both your TFSA and your RRSP – it doesn’t have to be one or the other. However, in many cases, it may be more beneficial to contribute to one account over the other.

Let's take a closer look at some key factors to consider when deciding where to direct your contributions this year:

• Tax deduction. Do you want or need a tax deduction in the current year? If so, contributing to your RRSP may be the superior choice. This is because an RRSP contribution results in an income tax deduction, whereas contributing to a TFSA does not. Quite simply, if you wish to lower your taxable income, direct your contribution toward your RRSP instead of your TFSA.
• Income now, and in retirement. If you’re in a higher marginal tax rate when you make your RRSP contribution, and a lower rate in retirement when you make a withdrawal, the RRSP can offer an additional benefit – the taxes saved upon contribution will be greater than the taxes paid upon withdrawal. On the other hand, if your current income is lower, you may suffer the opposite reality of paying more tax upon withdrawal from your RRSP than you saved when contributing. In general, RRSP contributions are more beneficial to those with higher incomes, while TFSA contributions may be a better choice for those with lower incomes.
• Sources of retirement income. What are your sources of income in retirement? Given that RRSP withdrawals are fully taxable, your RRSP/RRIF withdrawals could cause you to lose other income tested benefits, such as Old Age Security (OAS). On the other hand, TFSA income is entirely tax-free, is not considered income, and therefore does not jeopardize OAS or any other income tested benefits. In short, if you already have a significant taxable income in retirement, a TFSA can help provide you with a more tax-friendly retirement income stream.
• Family dynamics. Do you have a spouse or common law partner? If so, it could be advantageous to contribute to a spousal RRSP, particularly if your spouse or partner is expected to be in a lower tax bracket than you in retirement. A spousal RRSP strategy allows you to benefit from a tax deduction in the year your contribution is made, while the subsequent withdrawal is taxable to your spouse or partner, ideally at a lower rate.
• Career trajectory. Do you expect a significant increase in your earnings in future years? If you're in a relatively low marginal tax bracket now and expect to be taxed at a higher rate in the future, TFSA contributions may be more beneficial in the short term. It can be advantageous to forego the deduction in your lower income years to benefit from a larger tax deduction in future years when your income, and corresponding marginal tax rate, is higher.

Bottom Line

Before deciding where to direct your contributions this year, ask yourself the questions outlined above to make a more informed decision and decide which course of action makes the most sense for you. Ultimately, your decision depends on your goals, time horizon, and your overall financial and tax situation, and should be discussed with your tax professional and your Edward Jones advisor.