Your Largest Expense: Taxes – RSP’s and TFSA’s for Canadians

When the average person is asked what their three largest expenses are, they probably say Housing, Transportation, and Food.  What a lot of people miss is the fact that their single largest expense may be tax.  Especially when you add it all up – federal income tax, provincial income tax, sales tax, capital gain tax, dividend tax, etc.  When I look back on 2020, my personal income tax (not including other taxes) exceeded my total expenses (essential and discretionary) by 2x.  That’s right, my tax bill was twice as much as ALL OF MY EXPENSES COMBINED!   I know I am not alone here.  As has been said before, the only sure things in life are death and taxes.  You aren’t able to avoid paying taxes, however there are numerous legal ways to pay less.  The government of Canada has created tax-advantaged savings vehicles that Canadians can use to reduce their overall tax bill.  You can tell that most of these vehicles are worthwhile since the government has capped the maximum amount that you can put into each of these.  If they didn’t save you tax dollars (decreasing dollars going to the Canada Revenue Agency), they wouldn’t have maximum contribution limits.  I have outlined the two key plans that Canadians can use to reduce their tax bill below:

Registered Savings Plan (RSP)
  • How much can you contribute?
    • 18% of your earned income in the previous year up to an annual limit (for 2021, the annual limit is $27,830 – note that the limit changes every year)
      • Unused RSP contribution room can be carried forward indefinitely
    • Your personal RSP contribution room can be found on CRA online, on your notice of assessment, or on Form T1028
      • It is best to check your personal contribution room since it can be different from the contribution limit noted above due to Past Service Pension Adjustments and Pension Adjustments (complicated adjustments that go beyond the scope of this post)
  • What is the benefit of an RSP?
    • Deferred tax! – Contributions within the limit are tax deductible (i.e. reduces your taxable income in the year of the contribution).  Tax will eventually have to be paid upon withdrawal, however between contribution and withdrawal, the investments can grow tax-free
    • Some employers offer RSP contribution matching – Check with your employer if you aren’t already signed up!
    • Home buyers plan – You can take up to $35,000 out of your RSP to put towards the down payment on your first home and you won’t be taxed on it.  However, you do have to pay it back into your RSP over the next 15 years (keep in mind that if you do this, you will miss out on the growth during this period of time)
    • Lifelong learning plan – you can take up to $10,000 in a calendar year (up to $20,000 in total) from your RSP to finance full-time training or education for you or your spouse or common-law partner.  However, you do have to pay it back into your RSP over the next 10 years (as above, keep in mind that if you do this you will miss out on the growth during this period of time)
  • What can I invest in?
    • An RSP is an account (not an investment).  You can hold various investments within an RSP account
    • According to the Canada.ca website, RSP is “an investment in properties (except real property), including money, guaranteed investment certificates, government and corporate bonds, mutual funds, and securities listed on a designated stock exchange”
    • An RSP can be self-directed (you can manage it yourself) or professionally managed (using a professional money manager)
  • What to watch out for?
    • This is a LONG TERM savings vehicle – don’t contribute to an RSP unless you are sure you will not need the money until you plan to take it out (e.g. don’t use an RSP as an emergency fund)
      • If you have to withdraw your RSP early, your withdrawal will be subject to tax – the withdrawal will be added to your taxable income for the year
      • If you withdraw, you lose that contribution room permanently
    • Optimize your contribution by thinking about what tax bracket you are in and how a tax-deductible RSP contribution may reduce your income and put you in a lower bracket
      • Example (using made up numbers for simplicity)
        • Assume
          • Taxable income of $52,000
          • You have unused RSP contribution room of $9,000
          • Tax rates (Canada has progressive tax rates whereby your tax rate increases as your income increases).  The below are illustrative only
            • 25% up to $50,000
            • 30% above $50,000
        • If you contribute the full $9,000, your taxable income will reduce to $43,000
          • Your total tax savings will be $2,350 (calculation below)
            • 30% x $2,000 = $600 (you get 30% benefit until your taxable income drops to the bracket threshold of $50,000)
            • 25% x $7,000 = $1,750 (once your taxable income drops below $50,000, you only get a 25% benefit since you have dropped a tax bracket.  In this case you may be better off making a partial contribution this year, e.g. only contributing enough to get you to the $50,000 threshold where your tax rate increases from 25% to 30% and then carrying forward the rest if you expect to be in a higher tax bracket in the future)
      • This is a bit more complex so please reach out to me if you need help
    • The deadline for RSP contribution is always 60 days after the end of the previous year (to be eligible for a deduction for the 2020 tax year, you would have had to contribute to your RSP by March 1, 2021
    • Don’t overcontribute – steep penalties apply
    • When you withdraw money from your RSP, the amount that you withdraw is added to your taxable income that year.  The idea is that you contribute when you are working and are in a higher tax bracket, the money grows all throughout your career tax-free, and then you get taxed when you withdraw it during your retirement – when your income is lower and you will likely be in a lower tax bracket
    • When you turn 71, you have to convert your RSP into a Registered Retirement Income Fund (RRIF) and are required to make minimum withdrawals each year
  • More here
Tax Free Savings Account (“TFSA”)
  • How much can you contribute?
    • You start accumulating TFSA room the year you turn 18 years old, and you continue to accumulate contribution room until you die
    • The annual TFSA dollar limits by calendar year are as follow:
      • 2009 to 2012: $5,000
      • 2013 to 2014: $5,500
      • 2015: $10,000
      • 2016 to 2018: $5,500
      • 2019 to 2020: $6,000
    • Unused contributions can be carried forward to future years
    • You will not accumulate contribution room if you are a non-resident
  • What is the benefit of a TFSA?
    • Investments within a TFSA grow tax-free, and are not taxed when you withdraw them (however a TFSA contribution is made with after-tax dollars)
    • Suitable for short term savings – withdrawals from TFSA’s are not subject to tax and you don’t lose your contribution room permanently (your withdrawal in a given year is added back to the following year’s contribution room)
  • What can I invest in?
    • Similar to RSP, TFSA is an account (not an investment).  You can hold investments within a TFSA account.  The “Savings Account” part of the name is quite misleading
    • You can invest in the same types of investments that are permitted for an RSP
    • Also similar to RSP, TFSA can be self-directed or professionally managed
  • What to watch out for?
    • TFSA contributions are made with after-tax dollars (you do not get a tax deduction for contributing to your TFSA)
    • Don’t overcontribute to your TFSA as penalties for overcontribution can be very steep
  • More here
RSP or TFSA?
  • You may wonder whether it is more advantageous to contribute to an RSP or a TFSA
  • Optimally, I say do both!  I max both my RSP and TFSA every year.  That said, this may not be feasible for everyone.  Whether to contribute to your RSP or TFSA first depends a lot on your individual circumstance
    • If you are a high income earner now and paying tax at a higher marginal tax rate now than what you expect to pay in retirement, contributing to your RSP first probably makes more sense
    • If you are a low income earner now and are likely to pay tax at the same or lower marginal tax rate in retirement, contributing to your TFSA might make more sense
  • Liquidity
    • Don’t fund your RSP unless you are absolutely sure you won’t be needing the money for a very long time.  If there is any doubt, contribute to your TFSA instead – where withdrawals and deposits are flexible
      • With the RSP, you get hit with tax when you withdraw.  In addition, you can’t put money back in – you lose the contribution room forever

Disclaimer: Please note that I am NOT an accountant / tax professional and all of the above are only my opinions, NOT tax advice.  Please make sure you consult with a qualified tax accountant / professional before executing any tax strategies. 

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