Counter the effects of inflation with an RRSP and TFSA

4 min.

Inflation negatively affects your current and future finances. The tax advantages of an RRSP and TFSA could help you mitigate the cost of inflation. Find out how.

The effects of inflation on savings

It’s nothing new: the continuous climbing of the cost of goods and services, which we call “inflation,” has an inverse effect on purchasing power. The most insidious effects that inflation can have on your future savings are, however, less well known:

  • The decreased value of money also affects the value of your returns. If your returns are less than inflation or if your savings are sitting in a bank account, their value could fall below the cost of living.
  • Many factors can discourage you from saving, such as bad investments or the increasing cost of debt due to the rising interest rates that often follow on the heels of inflation. Higher prices can also compromise your ability to save.
  • Every dollar you don’t save in an attempt to resist the rising prices decreases the growth potential of your savings.

The example of diminished real returns
If inflation is 4% one year and if, that same year, your savings generate a return of 3%, the purchasing power of your savings the following year will have fallen by 1%.

Your real return for that period will therefore be -1% and your savings will equal 99% of the value of goods and services you would have been able to purchase before. If this trend were to continue, the loss of purchasing power could compromise your quality of life in retirement.

The example of reduced growth potential
If you were to save $3,000 less than expected during a period of inflation, you would lose potential returns for each unsaved dollar. This loss of potential can add up to major sums over the long-term.

For example, had you invested those $3,000 and received an average annual return of 5% over a period of 20 years, that sum could have reached approximately $7,960.

Maximizing your savings with an RRSP and TFSA

Luckily, there are solutions to resist inflation’s impact on your savings. The tax advantages of the Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) make them effective tools to help win this battle.

  • By contributing to an RRSP, you reduce your current taxable income, which could even result in a tax refund. If you have the means, you could reinvest this refund to increase the growth potential of your savings. This can also help you attenuate the rising cost of living.
  • Investments in your RRSP and TFSA grow tax free. As long as they remain in those accounts, your returns won't be taxed. This can help offset the effects that inflation has on your returns.
  • Unlike in an RRSP, contributions made to a TFSA aren't tax-deductible. Returns generated within the account are, however, not taxable upon withdrawal. These additional funds can also help compensate for the effects of inflation.
  • As long as your savings aren’t invested in a term investment, such as a guaranteed interest fund, you can withdraw funds from your TFSA at any time. This makes it an interesting tool for building an emergency fund, which could be helpful in times of inflation.
  • Over the years, the investments in your RRSP and TFSA generate returns on more than just your capital. In fact, the returns already accumulating tax free grow as well. This is called compound interest and its “snowball effect” accelerates your saving, helping you fight inflation.

Knowing your marginal effective tax rate can help you plan your contributions to optimize the benefits.

Also, because the amounts you save in an RRSP are only taxable upon withdrawal, you can calculate what amounts to withdraw in retirement such that the tax rate you’re comfortable with is applied to your income. That way, you’ll get the most out of every dollar you save.

How to continue saving?

Understanding the inflation spiral and its medium- and long-term effects sheds light on the importance of continuing to save through periods of inflation. If you don’t feel up to it, here are some ideas to help you out:

  • Treat saving like an essential good and set up automatic withdrawals to reduce your nonessential expenses. By protecting your savings in this way, you make them a priority, even during times of inflation.
  • Adjust your budget according to the economic conditions. This enables you to reorganize your expenses and improve the adjustments you make to protect your savings and purchasing power.
  • Benefit from the tax advantages offered by an RRSP and TFSA.

Above all, don’t hesitate to speak with an advisor; they’ll help you find the best ways to save in periods of inflation, according to your needs and goals.

Have you thought about the FHSA?
If you’re not a homeowner, the first home savings account (FHSA) is another great way to boost your savings in times of inflation.

Pairing the tax advantages of the RRSP and TFSA, contributions to your FHSA are tax-deductible and the withdrawals you make to buy a first home are tax-free!

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