Many people don’t know whether to choose a Registered Retirement Savings Plan (RRSP), a Tax-Free Savings Account (TFSA), or a combination of both to save for the future. In fact, choosing between a TFSA and an RRSP is easier than you think. TFSA makes sense for almost everyone, but RRSP is best for higher earners.
In this article, I’ll compare theses two types of accounts (TFSA vs RRSP). Understanding these investment tools will help you decide when to use one or both of them to achieve your financial goals.
WHAT IS TFSA
TFSA is a savings account introduced in 2009 to encourage Canadians to save more. It is a flexible savings tool that allows you to grow your investments tax-free.
CRA adjusts annually for inflation to determine the amount of contributions for the year. The amount of contribution for 2022 is $6,000. Assuming you were eligible to contribute in 2009 when the account was introduced (at least 18 years old), you will have a cumulative contribution of $81,500 by 2022.
When you contribute to a TFSA, the money you deposit is after-tax and is not tax deductible at the time of contribution. Income earned from investments within the TFSA is not taxed. Withdrawals from a TFSA are not taxable; they are not considered income and do not affect government benefits. Contribution limits generated after a withdrawal can be reinstated the following year.
Not sure of your contribution limits? You can verify this with the Canada Revenue Agency (CRA) “My Account”. Please be very careful about your contribution limits. If you exceed your contribution limit, you will be charged a penalty of 1% per month on the excess contribution.
WHAT IS RRSP
Introduced in 1957, RRSP allows you to contribute 18% of your annual income (the maximum limit in 2022 is $29,210) each year without paying any income tax on that amount.
If you contribute to an RRSP, the Canada Revenue Agency (CRA) will refund your taxes after you file your income tax return for that contribution year. This tax shelter structure allows you to defer paying taxes while saving for retirement. However, when you withdraw the money, you will need to pay taxes.
The basic idea is that your tax bracket in retirement will likely be lower than your tax bracket during your working period. Theoretically, by investing in an RRSP, you will pay lower taxes at last.
TFSA VS RRSP – WHICH IS BETTER?
There is no right answer suitable for everyone. It really depends on your tax rate, your financial plan, and what you want to achieve in what time frame. Here are a few common questions:
1. HIGH INCOME BRACKET VS. LOW INCOME BRACKET
People’s preferences for RRSP and TFSA vary by income. The tax advantage of RRSP is greater for higher income groups, as the money you put into an RRSP is tax-deductible, and your exemptions can effectively save you money on taxes immediately. So more higher income groups are more likely to purchase RRSP. The marginal tax rate for lower income groups is already relatively low, and buying an RRSP is not as advantageous, so it makes more sense to put the money into a TFSA.
2. YOUR FINANCIAL PLAN AND GOALS
When you invest, it’s best to know why you’re saving. You can have a short, medium and long-term financial goal. RRSP is an investment tool designed for your retirement and is suitable for retirement savings, but not for short-term or medium-term financial goals.
TFSA allows you to withdraw money at any time without incurring taxes or penalties. That’s why a TFSA may be more effective for short and medium-term investments. By using TFSA, you can achieve several small and medium-term goals, such as taking a vacation, buying a car, getting married, etc.
3. GROUP REGISTERED RETIREMENT SAVINGS PLANS (GROUP RRSPS)
This is a retirement savings plan that is sponsored by your employer. Generally, you contribute through regular deductions from your paycheck, and your employer matches the same percentage of your paycheck or a percentage of your contributions to your account. The money is for free, and this company benefit is certainly not to be missed. In addition, a portion of your employer’s contributions may also count toward your RRSP deduction for tax purposes.
However, this may not be ideal if the matching percentage is too low or if the investment options are not good enough.
4. HOME BUYERS PLAN (HBP) AND LIFETIME LEARNING PLAN (LLP)
RRSP is designed to help Canadians save enough money to live a comfortable retirement. However, it has two programs, the Home Buyer’s Plan (HBP) and the Lifetime Learning Program (LLP).
The HBP allows eligible homebuyers to withdraw up to $35,000 from the RRSP so they can contribute the amount of the purchase. This is one of two situations in which you can withdraw from your RRSP tax-free. However, you must repay the money within 15 years. HBP is a great way to get a lot of money, but it does work as effectively as an interest-free loan, which you must return.
On the other hand, LLP allows you to use your RRSP funds to finance full-time education or training for you or your spouse. For this purpose, you can withdraw $20,000 during two years, but you will need to repay the money within 10 years.
When you use a TFSA, you will not be subject to conditions or be required to repay the amount you withdraw for a limited period of time. Thus, a TFSA does a better job at both, provided you can stick to your goals and not resist taking the money out because the withdrawals are tax-free.
5. RETIREMENT PLANNING
Whether you are working or retired, withdrawals from your TFSA are tax-free. At the same time, any withdrawals from an RRSP will result in taxes. As a retiree, it is best for you to use both types of accounts to maximize your tax savings and investment income. When you retire, your tax bracket will likely be lower than it was before you retired. Therefore, your tax rate at the time of your RRSP withdrawal will be lower than your tax rate at the time of your initial contribution. If you have a tax refund, you can maximize the benefits of your investment by reinvesting the balance you receive in your TFSA.
With an RRSP, you will be forced to roll it over into a RRIF on December 31 of the year you turn 71. In contrast, a TFSA has no expiration date, and you can continue to enjoy the tax-free return on your investments in the account even long after you retire.
6. INHERITANCE
TFSA is also more advantageous than RRSP or RRIF. Normally, TFSA is not taxable at the time of the account holder’s death and is issued directly to the beneficiary; however, RRSP and RRIF are taxed at the market rate as income for the year in which they pass away, all of which is included in the final return of the deceased. Due to the large amount of income received in one lump sum, the tax bracket of the RRSP and RRIF account holder in that year will be raised and the tax rate will be even higher than the level at the time of contribution. In addition, if the spouse is still alive, both the RRSP and TFSA can add the spouse as a designated heir for tax deferral purposes.
7. SHOULD I HAVE BOTH AN RRSP AND A TSFA?
Ideally, you should have both a TFSA and an RRSP. A TFSA makes more sense for almost everyone, but an RRSP becomes more attractive when your income is higher or when your TFSA contribution room is capped. If the goal is to gain financial security, it’s much more practical to use two accounts than to stick with one. Once you understand that you can do better when you contribute to both, the TFSA vs RRSP debate may seem irrelevant.
Understanding the features and benefits of both account types, their tax implications, and your long-term goal will help you make the best decision between them.
8. TIMING OF RRSP PURCHASES
RRSP must be purchased in a timely manner if you want that to be tax deductible in the current year. For example, RRSP that can be placed in the 2021 personal income tax must be purchased by March 1, 2022.
9. THE “TFSA” TRAP FOR IMMIGRANT FAMILIES
The TFSA contribution amount is for Canadian tax residents. In addition, the TFSA amount shown on CRA website may be inaccurate, and CRA specifically states that the amount is for reference only.