With RRSP season coming soon, you may be starting to think about making an RRSP contribution, or you might be considering contributing to a TFSA instead. Before making your decisions, make sure you understand the tax implications of using Tax Free Savings Accounts. This will allow you to make investments strategically and realize the most tax savings.
The first step in investing strategically is to develop a plan and determine how you can meet your goals. As part of your plan, you need to think about the income tax consequences of making various investments, both immediate tax effects and long term tax effects.
TFSAs have no immediate tax effect, because contributions are not deductible, however, in the longer term, they offer significant tax savings. Growth in investments is not taxed, and withdrawals are not taxed. This makes them a very good choice for investments that will either grow rapidly, or whose income is taxed at a high rate, like interest income. As part of an overall plan, investments that earn interest income can be concentrated in a TFSA.
TFSAs are not ideal for investments that may result in a capital loss, because the loss cannot be used to offset taxable capital gains. For this reason, it may be better to keep equity type of investments in a non registered portfolio. TFSAs are not ideal for dividend yielding investments, because the dividend tax credit is lost. Similarly, investments with special tax treatments like flow through shares or income trust units should be held personally.
TFSAs can be very attractive for seniors, or those in a low income bracket, because withdrawals from TFSAs do not trigger clawback of Guaranteed Income Supplement, OAS, or other social benefit payments.
Although a TFSA contribution doesn’t result in a tax refund, it may well be the better choice for you, depending on your circumstances. Those in a higher tax bracket will appreciate the tax savings from RRSP contributions, while those in a low, or no, tax bracket may be better off contributing to a TFSA. People with a lot of high interest (credit card) debt may be better off to invest by reducing debt rather than make any RRSP or TFSA contribution.
If you aren’t sure about what, if any, investment to make, talk to your accountant or investment adviser early in the new year, before the RRSP deadline.