TFSAs and RRSPs: Which one is right for your financial future?
The cash stream has run dry for countless Canadians who have lost income due to the COVID-19 outbreak, but there could be short-term relief for those with savings in their tax-free savings accounts (TFSA), registered retirement savings plans (RRSP) or home equity lines of credit (HELOC).
The most efficient way to draw from any of the three sources depends on individual circumstances from both a tax and investment perspective. Here are the pros and cons of each.
Cash withdrawals from a TFSA are never taxed but for account holders who have contributed the maximum it’s important to know that the contribution space will not be restored until the following calendar year (2021).
If you have enough cash in your TFSA it’s a simple transfer, but if all your money is tied up in investments you need to consider the practicality of selling those investments right now to raise the cash. Markets are still reeling from the economic shock of the pandemic and you could be selling low.
The same logic applies to selling investments to raise cash in a RRSP, but RRSPs generally have more cash or fixed income to choose from because they are longer-term investment vehicles. The tax consequences, however, are much different. Since RRSP contributions are tax deductible when they are made, withdrawals are fully taxed unless they are used to purchase a first home or to go back to school.
But if you are experiencing a significant loss of income, there could be a tax advantage in withdrawing cash from an RRSP right now. The tax rate is based on your current income; the lower the income, the lower the tax rate. If, for example, you were in a 30-per-cent tax bracket when you made the contribution in better years, your refund was 30 cents on the dollar. If you withdraw in a year when your income is low, you might only be paying tax at a 20 per cent rate – or 20 cents on the dollar.
On the down side, if you make a withdrawal from your RRSP, you lose that contribution space forever.
The best RRSP tax strategy generates the biggest tax savings on contributions and the lowest tax bills when withdrawn in retirement, but there is a wrinkle if you tap into your RRSP before you turn 65. Early RRSP withdrawals are subject to a withholding tax. That means a certain amount is deducted at the source regardless of the individual’s tax bracket. In most of Canada, the withholding tax is 10 per cent for withdrawals up to $5,000, 20 per cent for withdrawals between $5,000 and $15,000 and 30 per cent over $15,000. Rates are slightly different in Quebec.
If your personal tax rate is lower than the withholding tax rate, the difference will be returned to you but not until you file next year.
If you own your home and have accumulated a significant amount of equity over time a home equity line of credit, or HELOC, could be the best short-term cash fix. Rates on HELOCs are as low as the average person can get because they are secured against an asset – your house. In other words, the equity portion of your home backs up the loan. The bank keeps the rate low because there is little risk the loan will not be paid one way or another.
HELOC rates are generally tied to the bank prime rate and ultimately the Bank of Canada benchmark rate, which is currently at a rock-bottom low of 0.25 per cent.
You won’t get a HELOC rate that low, but according to rate-tracker, Ratehub.ca, they are available for less than three per cent. With the economy in turmoil and central banks and governments practically giving away cash, it’s safe to say rates will remain low for a long time.
Borrowing through a HELOC is also tax-free. If you don’t already have a HELOC, establishing one will involve a few hundred dollars in legal and appraisal fees. Those fees – and the rate you pay – depend on your relationship with your bank. Don’t be afraid to negotiate.
Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email email@example.com.