Tax Motivated Savings Plans
Under the current tax legislation, Canadians have available to them several plans, each of which has different tax implications. All of the plans have one thing in common, they give the opportunity for your savings to grow on a tax free basis, in one case without even taxing this growth. The following is a brief outline of each.
There is often the question, should I save in my RRSP or my TFSA. The answer will depend on ones circumstances. The best idea is to invest in both, however cash flow is sometimes the deciding factor. RRSP contributions are tax deductible and all growth is not taxed until such time as the funds are drawn out of the plan, either by scheduled withdrawal or as the payments come out once the individual is 71 years old. In purchasing an RRSP one gets a current year deduction and deferral on all investment income earned in the plan. TFSA’s do not create a tax deduction. However, the investment income or growth earned within the TFSA is not only not taxed as earned, but is not taxed when withdrawn. Both of these plans should be a component of your retirement planning. Part of the decision should be based on what tax bracket you are in today and what bracket do you expect to be in when retired. Both plans are subject to annual limits. Your RRSP is limited to 18% of your prior years earned income plus any carry forward of contribution limit. This calculation is presented to each individual on the Notice of Assessment from the prior year. The dollar limit for 2011 is $22,450 (purchase required before February 29, 2012, and will be $22,970 for the 2012 tax return (therefore a 2011 earned income of $127,600 is needed to be eligible for the maximum 2012 RRSP contribution). For a TFSA the limit is cumulative, $5,000 per year for each year starting in 2009. Therefore if you are over 18 and have not contributed to a TFSA from the beginning, you would be eligible in 2012 to contribute up to $20,000. You can withdraw the contributions and any growth at any time without attracting tax. Any withdrawal made gets added to the next year’s eligibility so any amount withdrawn in 2012 can be redeposited any time after January 1, 2013. In both plans you need to respect the limits as there substantial penalties arising from over contributions. Back to the question posed, which to contribute to, a RRSP or a TFSA. If you expect your future income to be similar to your current income, the tax benefits of a RRSP and TFSA are similar. In other words, the value of the tax deduction from the RRSP contribution will generally equal the value of withdrawing the funds in your TFSA tax free. If it is expected that in the future you will be in a lower tax bracket, then saving in a RRSP will be worthwhile. On the other hand, if your income today is lower than you expect it to be in the future, then a TFSA is more beneficial. Finally, RRSP’s must be converted at age 71 whereas TFSA’s have no such deadline.
Another plan is a Registered Education Savings Plan. RESP’s allow you to save for a child or grandchild’s future education needs, no tax deduction on the contribution, however, tax on all of the earnings are deferred until the student starts to withdraw from the plan. As an additional incentive, the Government will make a Canada Education Savings Grant (CESG) of 20% of the first $2,500 contributed in the year. This money is also taxed in the hands of the student on withdrawal. It is possible, depending on the students other income and the amount of tuition paid, that the earnings and CESG could attract very little if any tax in the hands of the student. The lifetime limit on RESP contributions is $50,000 per beneficiary and the maximum lifetime CESG is $7200.
Similar to RESP’s is the Registered Disability Savings Plan. You can establish a RDSP for a child with a disability as long as they qualified for a disability tax credit. This plan allows you to put away funds to ensure there is money available for the long term needs of the disabled individual. As with RESP’s, the contributions are not tax deductible but the earnings are not taxed until such time as the funds are withdrawn by the disabled individual. There is no annual limit but there is a lifetime limit of $200,000. Contributions can be made to the plan until the beneficiary of the plan is 59.With RDSP’s there is a Canada Disability Savings Grant (CDSG) which like the CESG above, guarantee the growth of the contributions. The CDSG matches contributions at either 100%, 200% or 300%. The actual matching amount is determined by the total family income. Once the beneficiary is 60 years old, like the RRSP rules, payments must commence which are based on a formula. An individual’s RDSP is limited to CDSGof $3,500 annually and $70,000 over their lifetime. Finally, CDSP’s are paid into a RDSP up until the year the beneficiary turns 49.
The above listed plans should all be considered when one is doing their financial planning for each year. We at FGS can discuss with you what makes the best sense for you.