BIT Studio

December 19, 2009

TFSA vs. RSP

Filed under: BIT Financial — webmaster @ 8:04 pm

  A Tax Free Savings Account can provide flexibility and benefits for lower-income individuals that a RSP account cannot. A TFSA offers the same tax-free status on income generated, but TFSA contributions are not deductible from income and, more importantly, withdrawals are not taxable as income.

For example, a lower-income individual deposits $5,000 into a RSP and ten years later withdraws it at a similar or greater marginal tax rate (i.e. the income at time of deposit is the same or less than the income at time of withdrawal). All funds, including the compounded return, are fully taxable as income at the marginal rate in the year of withdrawal. In a TFSA, the same $5,000, which would have provided little savings in the way of RSP tax relief in the year of deposit, would generate an identical compounded return and upon withdrawal, neither the principle nor earnings would be taxable.

The primary objective in managing a Registered Savings Plan is to put money in at a higher tax bracket than when taking it out. Banks and government neglect promoting this aspect because (surprise!) it ultimately lowers their profitability. They heavily plug the tax-free status of income generated within the plan, however the ability to withdraw funds prior to the mandatory collapse date is equally important.

For example, a RSP deposit is made at a high marginal tax rate (say, $10,000 deposit on $100,000 income) and withdrawn ten years later at a lower marginal rate (say, $10,000 withdrawal on $50,000 income). After a safe compounded return rate of 2.5% per year, the marginal tax rate savings are almost as much as the compounded interest earnings, thereby nearly doubling the tax-free benefit. Leaving funds in a maturing RSP is inefficient and depending on the balance at the age-71 mandatory rollover, taxes could erase all marginal rate benefits.

RSP contributions are not for the young, the old, or the poor; they are for upper income earners to reduce high marginal tax rate liability. Properly managing your money takes time and planning. Consult a professional.

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