Planning for retirement may seem like a daunting task, but the Canadian government provides two major resources to help their people prepare for the later stages of their lives.
Today, we are going to break down both of these resources and identify when each of them should be used.
Let’s dive in!
A registered retirement savings plan, or RRSP for short, is considered the modern approach to retirement preparations for Canadians. It’s most attractive feature is it’s tax benefits.
RRSPs use a tax deferrings system, which means that you contribute your income before taxes. You will pay taxes down the road, but you will likely pay less when the taxes are deferred.
The idea behind retirement funds that defer taxes is that you can save money in the present while building savings for the future.
Also, Canada has a progressive income tax system, which means lower-income people pay less.
Let’s say you’re 40 and making $100,000 per year. Your taxes are much greater than when you’re on a considerably lower fixed income at 75 years old.
Wouldn’t it make sense to defer those taxes until you’re in a lower tax bracket?
One downside to RRSP is that users are penalized when they withdraw money outside of the permitted time frame.
RRSP accounts come with some contribution limits, but there is no penalty for over-contributing. You simply will not receive benefits on the contributions that exceed the limits.
RRSP is a great retirement plan for those who are young and have a decent income.
If you believe you’ll be making more after retirement because of residual income (investments, businesses, etc.), this may not be a great choice for you.
Also, there are some limitations on withdrawals, so you won’t want to use an RRSP if you are likely to need access to the money.
A tax-free savings account, which is often shortened to TFSA, is another approach to retirement preparation. This resource was introduced by the Canadian government in 2009.
The “savings account” bit of the name is sort of misleading since a TFSA is more than that. In addition to savings accounts, some of your contributions to the fund are put into stocks, bonds and more.
The reason behind diversifying the account is that savings accounts typically accrue less than 1% interest. When your interest rates are so low, the account loses value due to inflation.
However, when you mix in the other investments (like stocks and bonds), the return on the investment increases exponentially, allowing TFSA holders to grow their wealth and provide for themselves long term.
Canadians are able to contribute their income that has already been taxed to TFSA funds. People are not taxed upon the withdrawal of funds, no matter how much additional wealth is generated from the investments.
There aren't a lot of restrictions when it comes to withdrawing from your TFSA account. That means you can take money out if you need it before retirement. This is definitely an appealing benefit since so many people are scared to make long term investments in case they need to access their money.
One notable downfall of the TFSA is that there is a monthly contribution limit. The lifetime contribution limit for a TFSA account is just around $70,000 CAD. If you contribute above the limit, you will be penalized with a fee of 1% of the overage.
TFSAs are best suited for people who want to make consistent contributions to their retirement funds but want to have total access to the money in case of an emergency.
If you are looking to contribute large sums to your retirement fund each month, TFSAs are a great supplement, but due to their contribution limits, you’ll likely need at least one other fund.
It is important to note that TFSA is not a viable option for those who are looking to day-trade.
As we’ve mentioned, each of these options come with their own pros and cons. Neither is better than the other. It all comes down to your individual needs.
RRSP may be better suited for people who wish to make larger contributions to their retirement funds and have more financial security in the present.
TFSA may be better suited for those who want to contribute less and still want access to their money in case they need it.
Preparing for retirement doesn’t have to be overwhelming or stressful. With the help of tools like RRSP or TFSA, you can get your finances in check now so that you can enjoy your golden years without running out of resources.
Here at Remitbee, we support financial literacy, and we encourage you to begin thinking about your financial future as soon as possible.
Are you ready to start investing in your future?