The TFSA Might Be a Better Choice for You
One of the main reasons the TFSA was introduced was to give people in lower tax brackets a different (and possibly better) option for saving for retirement than the RRSP.
Unfortunately, too many people still don’t understand TFSAs and their benefits, leaving people either contributing to the RRSP without as much benefit as the TFSA could provide or worse, not saving at all. I hope this article sheds some light on the benefits of the TFSA for people in a lower tax bracket and gets them saving more efficiently for retirement.
What is considered a low tax bracket?
For the purpose of choosing to save and invest (this is a key word – see below for a common mistake!) in a TFSA instead of a RRSP, the majority of financial professionals suggest that if a person earns an income of about $50,000 or less, the TFSA might be the better choice.
RRSP vs TFSA for Low Income Tax Bracket
The RRSP works best for people in higher tax brackets because they get a tax rebate on their contributions based on THEIR marginal tax rate. The lower your income tax bracket, the less you get back for the SAME contribution.
For example: Someone making $100,000 a year who contributes $1,000 to their RRSP would get a tax rebate of about $430 while someone earning $45,000 making the SAME contribution of $1,000 would get a tax rebate of about $200.
The key to making the RRSP work to your advantage is to contribute while you are in a high marginal tax bracket, get the tax you paid back, and then withdraw funds in retirement and pay the tax then, when you are in a lower marginal tax bracket. (Most people have a lower income in retirement). However, if you are in a low marginal tax bracket, this advantage is less appealing. Instead, contributing to a TFSA is likely a better option.
The exception is if your employer offers a matching program for the RRSP. In this case, no matter what your income is, you should opt for 100% participation since this is free money. Any additional money you want to save can go to your TFSA.
The Benefits of A TFSA for Those in A Low Income Tax Bracket
Whether you invest through the RRSP or TFSA, you can hold the exact same investments – stocks, bonds, mutual funds, ETFs and more within each account. The RRSP has no advantage here.
The TFSA offers flexibility that a RRSP doesn’t. A TFSA allows you to withdraw funds anytime and for any reason, tax-free. Withdrawing funds from a TFSA for anything other than retirement or a planned saving purpose (future home down payment) generally isn’t recommended, but life happens and sometimes, having access to that cash can help avoid debt.
NOTHING TO LOSE:
If you begin earning a higher income, you can transfer funds from your TFSA to your RRSP tax-free. This will generate a tax rebate and in fact, you’ll get more back than you actually paid in taxes initially. Plus, you’ll earn back contribution room in your TFSA, giving you more room to save.
The TFSA Might Be Right for You If:
- You work part time while you go to school.
- You are early in your career and are earning a starting salary.
- You work part time while you raise your family or when you are semi-retired.
- You contribute to a basic pension at work that you know won’t be enough to retire on and want to save more for retirement.
- You’re retired and want to save for a future purchase or activity (cottage, travel, vehicle, renovation, home care) or want to leave a tax-free inheritance.
A Common Mistake Made with TFSAs
One common mistake I see people make is opening up a TFSA with their bank and holding that money in a high interest savings account. The tax-free feature of a TFSA will be most beneficial if the money held within it is INVESTED in stocks, ETFS, mutual funds and more, where potential growth is higher than a fixed interest rate offered by any type of savings account and therefore, the benefit of tax-free growth will be much greater.
Furthermore, you will not have enough for retirement if you hold your retirement funds in a savings account, even if it’s held within a TFSA for 50 years. Get it invested and use your savings account for short term goals only (examples: emergency fund, vacation, home down payment).
The RRSP and the TFSA are both excellent products and ideally, you can use both. The key is to understand when to use the TFSA instead of the RRSP, and vice versa. I offer free, 15-minute virtual Money Question sessions if you want to ask some questions about it.