RRSPs and TFSAs are great vehicles to shelter investments from tax while taking advantage of compounding. Yet investors often struggle to make the most of this opportunity to grow their money because they don’t contribute to their RRSPs and TFSAs as early as possible.
Let’s break down the key considerations for investors to get the most out of these tax-sheltered accounts.
Sooner is better
Anyone who can should max out both their RRSP and TFSA contributions as soon as possible so they can get tax-sheltered growth for longer. The benefits of additional compounding will accrue inside these plans, so the sooner you get the money inside the tax-sheltered accounts, the better.
How do you do that?
If you have the cash, invest it.
If you don’t have cash available, an in-kind contribution is one solution for anyone who holds other investments outside of their tax-sheltered accounts. Instead of waiting for a bonus or until you can save enough, you simply take an existing investment that is held outside your RRSP or TFSA and transfer it directly into one of these accounts.
Alternatively, you can liquidate one or more holdings to come up with the cash needed to make the contributions. That might take a few days because you need to wait for the sell order(s) to settle before you can actually use the newly-available cash to make a contribution. But liquidating holdings to re-invest is a bit more straightforward than an in-kind contribution, because with that kind of transfer you need to figure out how many units or shares to transfer to match your contribution allowances.
RRSP loans are typically only available early in the New Year ahead of the March RRSP contribution deadline for the most recent tax year.
An RRSP loan gives you the ability to get a quick tax refund by making the RRSP contribution, which is then used to pay off or down the RRSP loan.
Those who want to get that tax-free growth going sooner could borrow to invest in an RRSP, but borrowing to invest is tricky. You need to assess the possibility that the interest cost of the loan exceeds the expected returns you could earn by investing the borrowed money.
RRSP or TFSA?
On top of how soon to invest and with what money, people often ask whether it makes more sense to invest in an RRSP or TFSA first.
The common approach is to encourage lower-income earners to contribute to a TFSA first, so that the tax deductibility of RRSP contributions is of greater benefit to them in the future when they will presumably be earning more.
Investors also tend to use TFSAs to save for large purchases like a home or new car, and RRSPs to save for retirement. It really hinges on the individual investor and their goals, and whether the most important ones are short term or long term.
How to withdraw RRSP money tax-free
Programs like the Home Buyers and Lifelong Learning Plans might also influence whether you contribute to an RRSP or TFSA.
The Home Buyers and Lifelong Learning Plans let you withdraw money out of your RRSP tax free, as long as you satisfy the conditions for participation and with pre-specified repayment requirements.
These programs were launched before TFSAs became available, however, so they don’t hold as much appeal for investors today. If you have the money to contribute to only one type of account, the TFSA is far more flexible as you can withdraw money tax free at any time, for whatever you want, without any repayment requirements.
What about spousal plans?
A spousal RRSP allows one person to contribute to an account in their partner’s name and claim the amount they contributed as a tax deduction. It allows couples to split their income more equitably in retirement, which should reduce the overall amount of tax paid. The benefits became somewhat less compelling after income splitting was introduced in 2007, but they remain an option.
While there’s no corresponding spousal TFSA, investors can give money to their spouse to contribute to a TFSA in their own name. There are no tax deductions, but the income earned on money invested in a TFSA is tax free so it makes sense for some couples to have the higher-income spouse add funds to a partner’s TFSA before adding more to their own RRSP.
The RRSP contribution deadline is in early March, which gives investors an extra 60 days to make their contribution for the previous tax year once the calendar year end TFSA deadline has passed.
This only really matters for the timing of any relevant tax deductions though, because unused contribution room accumulates. You don’t forfeit the opportunity to contribute to your tax-sheltered accounts, but you do miss out on the benefits of your chosen investments potentially growing tax free over a long period of time.
That’s because when it comes to making the best of compounding, time is money.