Which Contribution Comes First: RRSP, RESP, or Tax Free Savings Account???
Posted on 31 January, 2010 | 61 Comments
Over the last 50 years, the Canadian government has introduced numerous tax sheltered vehicles to help Canadians in our pursuit of a richer retirement, a higher education, and just some plain old tax relief. For those in the upper income tax brackets and with excess cash flow, contributing to all three plans is a no brainer. But for those who fall outside this category, especially successful self-employed individuals who tend to have small salaries and large dividend payments, some of the plans including the RRSP have less benefit than one might think.
Let’s first quickly review the history of each of the three plans:
Registered Retirement Savings Plans (RRSPs) were first introduced in 1957 by the Liberal government to assist the thousands of people without a company sponsored pension plan. Maximum annual contributions were the lesser of $2,000 or 10% of your income which was a lot back then.
Registered Education Savings Plans (RESPs) were technically introduced in 1974 but really only became popular in 1998 after the government added a 20% credit (up to $400) on the first $2,000 contributed to the plan, otherwise known as the Canada Education Savings Plan.
Finally, Tax Free Savings (TFSAs) were introduced last year and allow Canadians to save $5,000 a year in a tax sheltered vehicle where income earned and withdrawals are free from any tax implications.
RRSPs
RRSPs provides two immediate benefits. (1) It provides a tax refund/credit and (2) investment returns are sheltered from tax. But RRSPs have a downside too that many financial advisers neglect. One way or another, the government collects its tax — it’s just a matter of when? Either upon retirement when the individual starts making withdrawals or upon death. Too often I read about financial advisers who make a very simple assumption that individuals will be in a lower tax bracket upon retirement. Unfortunately, this simply is not true. Many individuals and couples are able to build such a large nest egg that they continue to remain in a very high tax bracket. And with that being the case, I often recommend (especially to my self-employed clients) to contribute to a Tax Free Savings Account first (where funds are sheltered from tax forever and ever).
TFSAs
A number of papers have come out showing that individuals making less than $100,000 should probably contribute first to a TFSA and RRSP second even though no tax refund is offered on a TFSA.
Conceptually,this make senses because lower income individuals receive a smaller benefit of any RRSP tax rebate anyway, because they pay less tax in the first place than that of a higher income individual. In fact, a person who pays no tax at all and therefore receives no tax refund from any RRSP contribution, has no reason at all to favour an RRSP over the TFSA.
RESPs
Finally, RESPS are an interesting program, primarily because contributions are made with after-tax dollars but withdrawals are taxed in the child’s hands. One would think that the government should not be taxing RESP withdrawals if only because the dollars deposited into the RESP came from earnings that the parents had already paid tax on.
Hence, the RESP potentially exposes investors to double taxation. So long as the child is in the lowest tax bracket when he/she make withdrawals, there is no double taxation. But if the child is able to earn a university grant or scholarship, or even earns a salary through a part time job, then there is the potential for double taxation.
Where Do you Rank?
Typically, for my higher income clients, I rank RRSPs first, RESPs second (due to the 20% Canada Savings Grants), and TSFAs a close third. But like the TSFA, the onus for investing in an RESP becomes greater as investors fall into a lower tax bracket.
In fact, for some of my wealthy clients whose primary source of income is dividend income from their corporations (as dividends do not generate RRSP contribution room), I often tell them to consider contributing to their TSFA first, RRSP second, and RESP third.
Jeff Kaminker
President, Frontwater Capital
www.fwcapital.ca
www.frontwater.ca
61 Responses to “Which Contribution Comes First: RRSP, RESP, or Tax Free Savings Account???”
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