After landing your first full time job the advice is often to start saving for retirement. Now it can be hard to convince a young person to put money away for an event that’s 40 years in the future. But what can be even more difficult is understanding where to save that hard earned cash. In Canada there are two excellent tax efficient ways to save for retirement. There’s the traditional Registered Retirement Savings Plan (RRSP) and since 2009 there’s the Tax Free Savings Account (TFSA). Both offer a fantastic technique to grow your money. Before deciding what is best for you, is to first understand how these two registered savings vehicles work.
Money contributed to an RRSP can be deducted from your taxable income. For example, if you contribute $2000 to your RRSP and you gross annual salary was $50,000, you could reduce your taxable income to $48,000. You wouldn’t have to pay federal income tax on the $2000. The money in the RRSP grows tax frees, so if your investment are doing well you’re also not required to pay capital gains. It also works the other way, if your investments lose money you can’t claim capital losses if you sell. With the RRSP you will pay income tax on the money you withdraw in retirement. The logic is your income bracket will be much lower at this time then during your working life resulting in an overall smaller tax burden.
When it comes to your TFSA your investments also grow tax free. The money you contribute is after tax dollars and does not reduce your taxable income. The bonus is when you withdraw the money you don’t have to pay any income tax on your gains. For example your investment could double and you can withdraw that tax free.
When the RRSP makes sense
Making an RRSP contribution makes more financial sense when you’re at your highest earning bracket. If you just landed your first job chances are you will earn more in the future. Using the previous example a $2000 RRSP contribution on a gross annual income of $50,000 would result in a tax savings of $593. But if you income was $100,000 that same contribution represents $869 in tax savings. That is 30% more money in your pocket with the same amount of money saved.
How do you choose?
If you want to get the full tax benefit, you can do two things.
If you believe you will be earning more later in your career, use your TFSA in the beginning to save for your retirement. The money will grow tax free. Once you are at your highest earning you could withdraw that money and contribute it to your RRSP, providing there is enough contribution room.
The other option is to continue to contribute to your RRSP but don’t claim the contribution until you are earning more (and paying more tax). It is a common misconception that you have to claim the contribution you made in the year you made it.
For those who forecast their income remaining in a lower tax bracket. The more tax efficient move may be to use your TFSA to save for retirement. You won’t get the tax benefit when you are saving. But in retirement you can withdraw the money tax free and without it affecting your other government benefits and credits.
Generally those who fall into a lower income tax bracket should take full advantage of the TFSA. This year you can contribute up to $5500. But those in the higher income brackets should focus more on RRSP contribution as the tax benefits is greater the more you make. Regardless of what you choose the fact that retirement saving is a priority means you’re already on the right track to a wealthy future.
Image Credit: 401(K) 2012