What’s the best way to save with tax-free interest? TFSA and RRSP

 

As we get closer to tax time, many start to think about the tax breaks offered by a registered plan but many may be confused about what they are looking for, what with all the acronyms.
The two most notable are TFSA and RRSP. They aren’t the same, nor do they serve the same purpose.
The Tax-Free Savings Account (TFSA) is a flexible, registered, general-purpose savings account that earns tax-free interest. Canadians can contribute up to $5,500 annually into a TFSA and can withdraw the money in the account at any time. The money contributed to the TFSA is not tax exempt, though, as it is with an RRSP. The benefit of a TFSA is that you can save up for anything and collect interest that you can put toward whatever you decide to spend it on.
An RRSP is a retirement savings plan into which you or your spouse or common-law partner contributes to a set limit, dependent on your income for that year. RRSP contributions can be used to reduce the income tax you pay and the interest accrued is also sheltered from tax. You do, however, pay tax on the withdrawal at the time of withdrawal. The RRSP is a great retirement savings tool because you can contribute to it in your high-income earning years to reduce your tax owing, and then use the money as income in the future when your earnings may put you in a lower tax bracket.
RRSPs help you meet long-term financial objectives such as comfortably living in pension years, while TFSAs allow you to save for short to long-term goals.
Both allow you to top up what you may have missed putting away in previous years, but you have to be careful with a TFSA that you don’t over-contribute per year, which would incur fees. Say you contribute $5,500 on January 1 and take all of that money out by the time you receive your tax refund. You cannot simply put the refund back into your TFSA because you would overstep your contribution limit. You have to wait until the following January to add it along with the $5,500 for that new year (so, you could add $11,000 on January 15, for example).
With an RRSP, the government tells you what you can contribute for the following year based on what you earned that year. It also factors in what unused contributions have carried over. Say your allowed contribution is $5,500; you put $3,000 into your RRSP and on your tax assessment and the government tells you that you can contribute $6,000 next year PLUS the $2,500 carried over from the previous year for a total of $8,500. You can put your tax refund toward the following year’s contribution. Say that’s $1,000, which means you can contribute another $7,500 until the deadline for the next year’s contribution. Withdrawals from an RRSP are taxable, so you cannot simply replace the money you take out (with a few exceptions, such as using it as a down-payment on a house) without it going against your allowance for the tax year.
One last important thing: on death, the RRSP is counted as income on the deceased’s final income tax return and added to the estate. The other alternative is to roll it over into the RRSP of a spouse, common-law partner or dependent, where the transfer is tax free and continues to grow tax free until such time as the new owner cashes it in or forwards it along to dependents on passing away.
On death, the amount in the TFSA of the deceased is generally passed along to the spouse or common-law partner.

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