Should you invest in a Tax Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP)? For most investors, the answer may be “a bit of both.”
If you have a looming short or medium-term need (under five years), the untaxed TFSA withdrawals are likely the right choice. For longer term retirement needs, you’ll want to invest in an RRSP, especially if you are in a high taxable income bracket today.
What is the Difference?
Both RRSPs and TFSAs can contain the same basket of investments whose growth and any earned income inside either account are sheltered from taxes. This includes cash and cash-like instruments, GICs, stocks, mutual or segregated funds, exchange-traded funds (ETFs), and bonds that generate interest, dividends, dividend reinvestment and capital gains.
However, the two investment options act very differently when it comes time to withdraw funds; RRSP withdrawals are taxed as income, TFSA withdrawals are not. Also, the TFSA contribution room is reinstated in the year following a withdrawal, so you can contribute, withdraw, and contribute again in the following year.
Tax Free Savings Account
Contributions to a TFSA are not tax deductible, and they do not reduce your taxable income. These after-tax deposits are not taxed when they are withdrawn, nor are any of the gains made inside a TFSA!
When you open a TFSA you must be 18 years of age and have a valid Social Insurance Number (SIN). At the time of opening, you can contribute all of your lifetime contribution room at once or over a period of time. Each year the same additional contribution room is added to everyone’s lifetime total.
For Canadians who have become non-residents, or for non-residents who pay Canadian tax, there are additional rules that you should be aware of. If you have foreign citizenship or ties to another country, contact CRA to verify the country’s contribution room before depositing to your TFSA.
Allowed deposit amounts are readily available from CRA, and avoiding over-contribution is very important as the penalty of one percent of over-contribution per month can prove significant.
An important distinction between TFSAs and RRSPs is that upon a TFSA withdrawal, the allowed contribution room is not lost; rather, it remains available in the next calendar year. Many investors will incur over-contribution penalties because they innocently payback the withdrawal in the same calendar year, creating an over-contribution. Just wait until after New Year’s Eve, and you will get your contribution room back.
As of 2021, the lifetime cumulative limit for TFSA contribution is $75,500 per person. Therefore, a couple could contribute a total of up to $151,000 to TFSAs if they were both eligible for the maximum contribution.
For example, if the invested funds earned 5% returns, the gain could be left inside the TFSA to grow further, or $7,550 of income (5% of $151,000) withdrawn with no tax obligations.
If the gains was earned outside a TFSA in a regular, non-registered account, that same $7,550 is subjected to the combined Federal and Provincial income tax (could be as as high as 53%), causing a tax obligation of just over $4,000, leaving only $3,500 for the investors.
Hence, any investor who has funds outside of a registered account and is paying income tax on returns, would likely benefit from a TFSA.
Registered Retirement Savings Plan
The “contribution room” is based on last year’s income level and is unique for everyone. Each year you can make an RRSP contribution up to eighteen percent of earned income from the previous year up to a prescribed maximum, less any pension adjustments. For the 2020 tax year, for example, the maximum allowed contribution is $27,230, up from $26,500 in 2019. The maximum amount in 2021 is $27,830. Any unused contribution room can be carried forward to the following year to arrive at your total available contribution room.
Your allowed amount is available from the CRA; you can also find this information on your Notice of Assessment or Notice of Reassessment, which the CRA sends after reviewing your annual tax return. In order to be eligible for RRSP contributions, an individual must earn an income and file a tax return.
How Do They Compare?
RRSPs and TFSAs were created with different goals in mind, which explains their different behaviour in relation to taxes.
Moneysense.ca explains this nicely:
“With an RRSP, you can deduct the contribution from your income, which (usually) earns you a tax refund, but the money becomes fully taxable when you take it out. The TFSA is the reverse: you don’t get a tax break on contributions, but you don’t pay tax on withdrawals either.
So if you’re deciding between the two options, the question boils down to whether you should pay the taxman now or later.”[1]
A good guideline to follow is: “If your income (and therefore your tax rate) is greater now than you expect it to be during retirement, go with the RRSP; if it’s lower, go with the TFSA.”[2]
Most people with a high salary and secure pension plan find more benefit from the TFSA because their pension, together with Old Age Security (OAS) and the Canada Pension Plan (CPP) could potentially increase their income high enough to prompt a claw-back of OAS when they withdraw from an RRSP that has been converted into an RRIF.
RRSPs, however, are often the most sensible for the majority of people. Those who are not high-income earners could immediately invest the tax refund received into a TFSA and benefit from the long-term tax-free and compound earnings.
Pros of RRSPs
- Immediate tax benefit
- Funds can be deposited in a Spousal RRSP to lower taxes pre and post retirement
- Enforces discipline because tax implications limit when funds can be withdrawn
- At death, RRSPs can be transferred to the surviving spouse. This election is best made directly with the institution and in-detail with a will. Both the institution and the will should contain clear and consistent elections and wording.
Pros of TFSAs
- Funds can be withdrawn from a TFSA at any time without any tax penalties
- TFSA spans a lifetime, does not present any tax liability at death like an RRSP
- Unlike an RRSP, the TFSA does not have to be converted to an income plan like an RRIF
Cons of RRSPs
- The investor will have to pay tax upon withdrawal, and a minimum, ten percent withholding at source is required with a maximum thirty percent for larger amounts
- If a withdrawal is made before retirement (and not for a first time house or you or your spouse attending school), the amount will be added to employment income and the increased amount will be subject to the prevailing Federal and Provincial marginal income tax rate
- Withdrawals result in permanent loss of contribution room
- Upon death, the entire balance of an RRSP, valued on the date of death, is considered to be withdrawn, converting the entire amount within the RRSP into income on the deceased terminal return (deceased’s last tax return for the tax year in which death occurred). If the balance is large enough, it can generate significant tax liability for the heirs.
Cons of TFSAs
- Funds can be withdrawn from a TFSA at any time making withdrawals tempting; investors must rely on self-discipline
- Repayments of withdrawals that put an individual over the maximum contribution are subject to severe penalties; investors must self-monitor, and wait until the following year
