RRSP vs TFSA for Independent contractors

The deadline for RRSP and TFSA are fast approaching (Feb 29, 2012) and many of our clients want to know whether it is more beneficial to contribute to an RRSP  or TFSA.  While the two investment vehicles are completely different they both have benefits.  Before we determine which path is best it is worthwhile to understand the pros and cons of each .

PROS of the RRSP:

• HI Contribution amount up to $21,000
• Provides tax deferral (Reduces taxable income when deposited increases taxable income when withdrawn)
• You can hold USD stocks
• Growth is  not taxed until funds  are withdrawn

CONS of the RRSP:

• You can’t take money out except for buying a home or for education for you or your spouse
• If you are in the lowest tax bracket tax savings are low and  you may pay higher tax rate in retirement if you have a pension

PROS of the TFSA:

• Grows completely tax free.
• Everyone can contribute $5000 starting from the age of 18.
• It is easy to get your money out

CONS of the TFSA:

• little contribution room available  ($5000 a year )
• does not reduce taxable income

 Determining which is best depends on the individuals circumstances.   Typically the tax strategy for independent consultants is to leave as much money inside the corporation and to pay the least amount of salary possible.  Due to this strategy RRSP contributions are not nearly as beneficial for contractors as they are for employees. While the tax savings may not be as lucrative, they still have a role to play.  My advice for clients is that contributing to an rrsp is beneficial up to the point where the tax savings brings you taxable income to below the lowest tax bracket (roughly 40,000).  If you are below this tax bracket and you have funds available it is better to contribute to you TFSA.  The most ideal tax planning strategy would be to declare a salary of $50,500, contribute $10,000 to your rrsps and contribute $5000 to your TFSA.  This would mean that your taxable income would be in the lowest tax bracket, your rrsp benefit would be received in the middle tax bracket, you would max out the CPP contribution and you would mac out your TFSA contribution. 

I typically recommend to max out the TFSA contribution because I believe clients should be able to generate high investment returns of over 10 % (see bobs video on financial coaching)  and because I believe it is important for IT consultants to have a cash reserve that can be used for emergencies.  While I believe contributing to RRSP`s is also beneficial the long term savings for IT contractors are limited and the strategy is mostly for tax deferral.  If you have the funds available to do both TFSA and RRSP great. If you had to choose one I would recommend a TFSA.

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