Today, I’m going to do a quick overview of what marginal taxes are, RRSPs, and how TFSAs are different from RRSPs.
Marginal Tax Rates
Imagine your gross income as money pouring out of a faucet and filling up buckets. Once the first one is filled, you get a second bucket, when that fills, you grab another one and so on. The first bucket gets taxed at the lowest rate, the second one higher, and the third one even higher and so on. The marginal rate is the tax applied to a particular bucket. You have to pay both federal and provincial taxes. The federal and provincial governments use different bucket sizes to measure your income and apply different marginal tax rates. Here are their rates for 2019.
Say I earned roughly $78k this year, this is how much I’m expecting to pay in taxes if I live in Ontario.
RRSPs and TFSAs
RRSP: Registered Retirement Savings Plan
TFSA: Tax-Free Savings Account
RRSPs and TFSAs are types of accounts you can open through any bank or brokerage company, like a special savings account. Both accounts give you different types of tax benefits. Due to the difference in tax benefits, each account has its pros and cons.
Skip to the end if you want a quick summary chart 🙂
Biggest similarity
Once you’ve put money in, you can buy investments within the account. As long as the money stays within the account, any gains from investments are tax-free and don’t count as income. More money for compound interest to work with.
Biggest difference on money going in
There’s no tax break for money going into a TFSA. The money you put in is “post-tax”. Now RRSPs, that’s where things get interesting.
If you deposit money into an RRSP account, it reduces your gross income and thus your marginal rate. You delay your taxes until retirement when you’ll most likely be in a lower tax bracket. So by delaying taxes, you’re also reducing your total lifetime taxes. Don’t even think about taking this money out before retirement, you get slapped with some really hefty penalties.
The contribution room is 18% of your previous year‘s reported income up to a maximum (check here). Let’s say I made $70k the previous year, I can put in 18% x 70000=$12,600 and have my income reduced to $70k-12.6k = $65.4k:
Pretty sweet deal. That’s a $3,735.90 difference between Chart 1 taxes and Chart 2 taxes. This money the government returns to you after you file tax returns can be put into more investments, double bonus!
Biggest difference on money coming out
TFSAs don’t give you a tax break when you put money in, but you pay no taxes on money coming out, including money you made in investments.
Withdrawals from
Together, these two types of accounts are called tax-advantaged accounts. Both will allow your money to grow without the growth being taxed. The advantage of a TFSA is that your withdrawals are tax-free. The advantage of an RRSP is that you get a tax break now.
You should aim to contribute the maximum to both of these accounts. The general advice is to max out your TFSA and then your RRSP. For me, it was nearing the RRSP deadline for this year so I shoved money into that first and am now working on my TFSA. My TFSA bucket can hold more than $50,000 by this point and considering my net worth is less than half that I have some work to do. Be careful not to over-contribute to either account, it does come with penalties.
How do I get an RRSP or TFSA account
Talk to your bank and just open one, super easy. Brokerage companies will also offer these type of accounts under which you can make trades and investments.
Don’t sweat the details, open both accounts today and put money into them! It’s unfortunately too late for the 2018 tax year (good timing of this post eh?) but you can get into the habit now. I set up auto-deductions into my RRSP account on a monthly basis.
Summary Chart
*It feels odd writing an article about things I feel most other people know already. But then again, I didn’t know these things before this year either so somebody will surely benefit.