You’ve spent a long time, a lot of effort and a fair bit of money to get going in your career. Now here you are launching into it, and likely the last thing you’re thinking about is … retirement.
Fair enough, let’s not stretch too many decades down the road, and just look a few years ahead for now. Why is it so important to get a savings habit going now? And how can taxes – yes, taxes – act as a strategic guide on where and when to invest those savings?
Save early, save often … and save smartly
In terms of what is saving smartly, ideally your savings will be flexible to be applied to your financial needs as they arise, and will take best advantage of tax-sheltering where possible.
Choices: RRSP and TFSA
While not the only place to put your savings, registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs) are common choices:
RRSP – You get a tax deduction for the amount you put in, there is no tax on earnings while in the plan, and then withdrawals are taxable.
TFSA – There is no tax deduction when money goes in, but similar to RRSPs there is no tax on earnings, and all withdrawals are tax-free.
In a sense, the RRSP and TFSA mirror one another in that the big tax break comes at the beginning with the RRSP and at the end with the TFSA. Apart from the tax-sheltering (which both plans get), an RRSP makes sense for retirees because they expect to be in a lower bracket in retirement when withdrawals are taxed. If you used a TFSA for this purpose, it would cost you more tax than with the RRSP.
So if that’s the case, is there any situation when a TFSA would be preferred because someone goes up in tax bracket over time?
A tax strategy for young earners
Yes, and you’re it as a new entrant into the workforce. You’ve negotiated a fair wage to begin, but you expect that to rise as your career progresses. The value of the tax break on an RRSP contribution is more modest at this level than it will be when you fully hit your stride later on.
It may not sound appealing to allow yourself to be taxed now, but that’s what happens if you first contribute to a TFSA. Then when you get into that higher income (and tax) bracket, you can take your tax-free TFSA withdrawal to make your tax-deductible RRSP contribution. What you do with your eventual tax refund … well that’s a topic for another day.
What’s more, you are allowed to re-contribute to your TFSA in future years what you took out of it this year. With a little planning you can strategically use the TFSA over and again throughout your life. Of course there’s much more to consider than this little tax hook, not the least of which is the choice of investments within the accounts. That’s where a conversation with your financial advisor can help you decide if and how to apply this strategy in your situation.