Topping up RSPs vs Tax-Free Savings Accounts

Trying to figure out whether to put your retirement money into a TFSA or RSP? I know it can be confusing. I get questions on this topic all the time, so I knew I had to do a podcast on it. With the RSP deadline coming up, I knew it was the right time.

I’m going to put a couple questions to you about your financial situation, followed up with some sound tax advice that will help you begin to figure out what works best for you. These decisions should be based on things like taxable income and if you’ve got a workplace pension…so I’m breaking it all down.

There really is no one-size-fits-all solution when it comes to managing money, so take take a 👂 now and making the most of your retirement savings.

Show Notes:

Hello, and welcome back to another round of our “Heart of Our Money Talks”. This is episode nine and in the spirit of the RSP deadline season looming, I’m going to share with you today one of the most frequent questions I get asked, which is, “Should I be Topping up RSPs or investing my tax-free savings account?”

This answer is so different for everyone and it’s based on your own personal circumstance.

So I’m going to give you a few hints and ask you a couple of questions that will help you decipher your best choice. If you are topping up RSPs, you’ll receive a tax slip that you can use to reduce your taxable income. A tax-free savings account will not provide you any deductions and you won’t get a slip at the end of the year.

But here’s the good news…you won’t have to pay tax when you start taking money out of that TFSA. You can use either the RSP bucket or the TFSA bucket to invest any way you want. Some people think that TFSAs are only high-interest savings accounts at the bank…the 0.8% interest cash savings. That’s not true.

You can have a tax-free savings account and the RSP as well. In each of these buckets, you can put anything inside of it and invest any way you like. Let’s say you came to me and said, “I have an extra amount of money that I want to allocate for my retirement savings. Should I be topping up RSPs or my tax-free savings account?”

So one of the questions I’ll ask you is, “What is your taxable income for the year?”

This will give an idea of how much of an RSP contribution will help you at tax time. The more money you make, the higher tax bracket you’re in, and that’s when an RSP contribution will really help you and give you tax savings.

I’m going to give you an example and let’s just use an example of an average income amount. If you make under $49,000 a year, your RSP contribution will not give you a big tax saving. This is when a tax -free savings account might be more appealing.

Think of an average example of a 15% tax rate.

If you make $49,000 a year, a 15% tax rate is what you would pay. So that means for an RSP contribution you would only get 15 cents on every dollar that you contribute to an RSP as a tax deduction. Now, if you make $100,000 a year, you’ll be at a 26% tax rate, so you get better tax savings.

You get a bigger bang for your buck if you have a higher income rate.

So your taxable income for the year is one of the basic guidelines to use for making this decision. It’s just the basic first question that I would ask.

Okay, the next question I’ll ask you is, “Do you have a pension at work?”

This would be a registered savings bucket, and it would mean that you’re already contributing to a bucket that would be taxed in retirement when you go to take it out.

If a person only has registered money in retirement, and a lot of it, great. Good job saving, but it’s also all taxable income when you retire.

The Canada Revenue Agency is going to get their pound of flesh no matter what, and they give you a nice tax break with your RSP slip when you go to contribute to it.

ut then they’re also going to say, “Oh, by the way, when you go to take out of your RSP in retirement, we’re going to also tax you on that as well.”

So here’s an example.

In retirement, you might want to buy a car outright, or you might want to take that once in a lifetime trip or you want to renovate the kitchen. Let’s just say, hypothetically, for this example, you need $50,000. Okay, so you’ve done the math. You have enough savings that will last a lifetime. You have enough investments.

So taking out $50,000 will not make you run out of money, but it’s all registered. You’ve got it all in RSPs. So here’s the kick. You’re going to be paying tax out the ying-yang to take out such a large amount on top of your monthly income that you’re getting from your registered pension or your RSPs that are paying you monthly retirement income.

Yes, you have enough assets, you have enough wealth that it works, but the tax on it is just going to be horrendous. So this is why having a tax-free savings account in retirement is nice…having that TFSA bucket filled for the circumstances means that you can mitigate tax.

Okay. Back to the question, “Do you have a pension at work?”

If yes, do you have only registered savings and you want to diversify your retirement savings to include a tax-free savings account?

RSPs are good choices for higher incomes. If you know that in retirement and you’ll be in a lower tax bracket than while you’re working, you’ll need a financial plan or a map.

To know that though you’re going to want a picture of life right now, and then five years, 10 years, and 20 years from now. To show you that guideline, you need a financial planner. So before you start investing and making contributions, you should have that mapped out, otherwise, you’re winging it. But these two questions I gave you about your taxable income and if you have a registered savings pension at work will help you to come up with the best choice for you.

So I want to share a couple of examples that might help make sense for you or bring a little bit of clarity. The first example is for younger people, maybe the millennials, that just finished university.

Let’s just say, hypothetically, they’re starting out and they got their first job and they’re making $50,000 a year. So now they’ve got this extra amount per month, they’re saying they want to do the right thing and start putting money away.

Now they’re wondering if they should be investing in an RSP or a tax-free savings account.

If you just graduated, you might still have tuition credits to use at tax time, and you might have the graduate retention tax breaks so that your taxable income drops by quite a bit, so investing in a tax-free savings account might be the way to go.

Then as you earn more and your tax credits are used up, you can use the tax-free savings account to then make an RSP contribution later when you’ll get a bigger bang for your buck with the tax break. As you make more money, remember, you can still invest in anything in that TFSA so you can have your investment grow.

You can even have the compound interest in dividends until it’s a better time to use it towards an RSP contribution.

So that’s an example of someone that is just on the cusp of that income-earning and they know that they’re going to grow and later on have a higher income. So you’ve got some flexibility there.

Here’s another example and it’s very common. It’s one that I come across a lot in our planning.

This example is let’s just say you have a partner, you and your partner both make really good money. Let’s say you both make over $80,000. It doesn’t matter how much, but it’s pretty darn good.

You’re in a higher tax bracket and you both have a defined benefit pension. Now that’s the pension that pays you a certain amount each month, no matter what for the rest of your life. So in this example, you both have pensions when you retire and you cannot decide to change the amounts that you receive in retirement.

Remember with that defined benefit pension, it’s a monthly amount guaranteed for the rest of your life…no matter what, there’s no flexibility. You can’t turn up the amount; you can’t turn down the amount. It’s no matter what, it’s like a life annuity.

You don’t have the flexibility to then say, you know what, this year, I just want to take out a lump sum and next year we won’t need anything.

Here’s the most common one that comes across my office. People want to renovate their kitchen or they need to pay for a new roof. This is an example of when people having a defined benefit pension need to have those tax-free savings in retirement so that they’ve got the flexibility to take out more money.

It’s supplementary income that’s not taxed, and it gives the flexibility to be able to pull out money for unforeseen costs.

Then there’s this part that we need, you might not even think about is that it’s also part of estate planning, in terms of the defined benefit pensions upon death.

There’s nothing there that pays out to the estate. So if legacy or estate planning is important to you, you won’t have that, but the tax-free savings accounts will. It’s another reason to have some diversification for a couple that only has their two pensions, so while they’re saving, hopefully they’re also adding to their tax-free savings accounts and not to more registered money.

To truly know what you should be saving in the RSP, or TFSA, talk to a financial planner. They’ll be able to go through this with you. You should have a financial plan and have this mapped out for you. It needs to be addressed every year in our office. We sit down after each tax filing, review the returns, and peel back the onion a little bit more.

If we map out the coming year and then we decide this year RSP or TFSA, or is there enough for both? What’s the plan?

There’s more to it than these two questions I gave you, which is about how much you make and if you have a pension or registered money already. If there is a little bit more, you want to make sure that it matches your plans, your personal objectives and what you want in your life goals.

But these two questions will definitely start to weed out and bring some clarity. So the best-case scenario would be that we’re rolling in the money and we could max out our RSP contributions every year, and we could also max out our tax-free savings accounts every year. That’s the optimal choice.

But then reality hits and life happens. We know there are bills and there are other needs, and so we do have to start making some priorities and choices. So be kind to yourself, just stay informed. I love this quote…”Success is the sum of small efforts”.

Just starting some savings is the key here.

If you have any questions or you’d like to talk more about this, shoot me a note. I love this stuff. I am a bit of a financial planning nerd, so I’d love to help you. That’s it until next week.

Take care.