RRSP vs. TFSA which one is better? Pick the best investment option

To read more chapters, click below:

Chapter 1: All that you want to know about RRSPs

Chapter 2: A novice’s guide to understanding RRSP contribution limits

Chapter 4: T5 Tax Form: Statement of Investment Income in Canada

In this chapter, we will outline the fundamental aspects of TFSAs and RRSPs, and how these investment choices can work to your advantage.  In this guide, we'll provide an overview of TFSA and RRSP accounts, along with key considerations for deciding where to invest your funds.

• RRSPs and TFSAs are government-backed tools designed to help Canadians secure their financial futures.
• RRSPs allow for tax deferral, providing immediate relief from income tax, with taxes being payable upon withdrawal.
• On the other hand, contributions to a TFSA do not provide immediate tax benefits; however, they offer the advantage of allowing tax-free withdrawals in the future.

What are TFSAs and RRSPs?

Tax-Free Savings Account or TFSA as it is popularly known as, is a financial account especially for the residents of Canada. It offers various benefits for savings and investing. The earnings on investments held within a TFSA, including interest, dividends, and capital gains, are not subject to income tax. This means that your money can grow tax-free over time. You are provided with an annual contribution limit by the Canadian government that you need to follow. You have a carryover contribution room that accrues annually for whatever you don’t utilize in a particular year. Savings accounts, GIC’s, stock, bond, and mutual fund among others, are all eligible for holding under TFSAs. The flexibility enables an investor to customize his or her TFSA according to specific investment interests and appetite for risks.

Registered Retirement Savings Plan or RRSP, is a tax-advantaged savings and investment account meant for residents of Canada. It is specially designed keeping in mind the requirement of Canadian residents to assist them in their savings for their retirement. An RRSP is tax deductible which means that your contribution reduces your taxable income for the year it’s contributed. This tax may result into lowering of your annual income tax bill. These may have – bonds, stocks, mutual funds, guaranteed investment certificates (GICs), and other types as well. The result is that you can create a flexible, flexible RRSP portfolio to meet your particular financial aims and attitude towards risk. For RRSPs, the Canadian government establishes yearly ceiling of contributions, which is dependent on your salary gains for the past calendar year. These are also cumulative and get added as part of the contribution for the following years if they are not utilized.

Similarities between TFSA and RRSP

Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs) are two completely different programs, but there can be some similarities between the two. Here’s how each of them is unique –

1. Tax Sheltering for Investments: With both TFSA and RRSPs you get targeted tax advantage for your investments. Within these accounts, you can hold a variety of investments, such as stocks, bonds, mutual funds, and more, and any income or gains generated within the account are tax-sheltered.
2. Compound Growth: Both accounts allow your investments to grow tax-free. With the passage of time, the compounding of interest, dividends, and capital gains has the potential to substantially grow your savings.
3. Flexible Investment Choices: Whether it is TFSA or RRSP, you get the freedom to choose your investment options in each of these. This means you can tailor your portfolio to align with your risk tolerance and financial goals.
4. Contribution Room: Both TFSA and RRSP come with yearly contribution limits that you need to adhere to. Contribution room accrues over time, and any unused room can be carried forward for use in subsequent years. The government sets annual contribution limits for each type of account.
5. Penalty for Overcontributions: Both accounts have penalties for contributing more than your available contribution room. For TFSAs, overcontributions are subject to a 1% monthly penalty. If you exceed the contribution limit in an RRSP you will have to pay 1% per month as penalty.
6. Spousal Contributions: You have the option to contribute to a spousal TFSA or RRSP, which can assist in balancing retirement income and mitigating the overall tax liabilities for the family.
7. Investment Flexibility Upon Death: If the account holder passes away, both the TFSA and RRSP accounts can be handed over to a spouse or designated beneficiary without the requirement for probate, making the asset transfer process smooth and straightforward.
8. Non-Reportable Income: Income generated within both TFSA and RRSP accounts is not reported on your annual income tax return. This reduces the administrative burden when filing taxes.
9. No Mandatory Withdrawals: Unlike some retirement accounts, such as Registered Retirement Income Funds (RRIFs), neither TFSA nor RRSP has mandatory withdrawal requirements during your lifetime. You have control over when and how much you withdraw.
10. Use for Retirement Planning: While TFSA is more flexible for various savings goals, both accounts can play a role in retirement planning. RRSPs are crafted with a focus on retirement planning, while TFSA contributes to enhancing your retirement income through the provision of tax-free withdrawals.

Despite these shared characteristics, it's essential to keep in mind that TFSA and RRSP have distinct primary objectives. The primary distinction lies in their respective purposes: TFSA serves as a savings tool, whereas RRSP is designed to assist with retirement planning. When deciding between the two, it's important to ensure that your choice aligns with your precise financial objectives and tax planning strategies.

Differences between TFSA and RRSP

Both TFSA and RRSP are valuable saving tools used in Canada. But they have distinct terms of their purpose, taxation, contribution limits, and withdrawal rules. Some of the main differences between TFSA and RRSP are –

Purpose

• TFSA: TFSA contributions are made with after-tax dollars, and the account is designed for various savings goals, including short-term goals like buying a car, saving for a vacation, creating an emergency fund, or long-term goals like retirement. TFSA withdrawals are tax-free and can be made for any purpose.
• RRSP: Contributions made to RRSPs can be subtracted from your taxable income, and these accounts are primarily structured for the purpose of retirement savings. While there are specific programs (Home Buyers' Plan and Lifelong Learning Plan) that allow for limited withdrawals for educational expenses or purchasing a first home, the primary focus is on retirement.

Taxation

• TFSA: Contributions to a TFSA are not tax-deductible. Any profits, interest, or dividends generated within the account are not subject to taxation. Moreover, when you make withdrawals from the account, those funds are also exempt from taxation. This tax-free status of investment gains and withdrawals is a distinctive advantage of this financial vehicle. It allows for the growth of your investments without incurring additional tax liabilities, enhancing the overall benefits of the account for long-term financial planning.
• RRSP:  When you contribute to an RRSP, you can deduct the contributed amount from your taxable income for that year, leading to a reduction in the income on which you're taxed. This provides an immediate tax benefit. However, it's essential to note that when you withdraw funds from an RRSP, these withdrawals are considered taxable income. This means that you will need to pay income tax on the amount you withdraw, which is a key consideration when planning your finances and retirement.

Contribution Limits

• TFSA: TFSA contribution room accumulates annually. The government determines the annual contribution limit, which may fluctuate from year to year. Unused contribution room carries forward to future years. As per the last update in September 2021, the Tax-Free Savings Account (TFSA) contribution limit in Canada was $6,000 per year. However, it's important to note that contribution limits for TFSAs can change annually, and the Canadian government may have made updates since then.
• RRSP: RRSP contribution room is based on your earned income and accumulates over time. The contribution limit is a proportion of your income, with an upper limit determined by the government. Any unused contribution room can be carried forward indefinitely, providing flexibility in managing your contributions over time. To find the most up-to-date RRSP contribution limit for the current tax year, it is recommended that you visit the official CRA website to know more or consult a professional financial advisor.

Withdrawal Rules

• TFSA: Any money you withdraw from your TFSA is tax-free. This includes both your original contributions and any investment earnings or capital gains. When you make a withdrawal from your TFSA, the amount you withdraw doesn't impact your contribution room. To put it simply we can say, if you've utilized your contribution room for a specific year and subsequently withdraw funds, you cannot redeposit that withdrawn amount until the following year. If you want to transfer funds between your TFSA and your spouse or common-law partner's TFSA, you can generally do so without tax consequences. If you withdraw $5,000 from your TFSA, you can contribute that $5,000 back into your TFSA in the next calendar year in addition to the new annual contribution limit.
• RRSP: When you withdraw funds from your RRSP, the amount taken out is treated as taxable income for the year in which the withdrawal occurs. Consequently, you are obligated to pay income tax on the withdrawn amount. This means you will owe income tax on the withdrawn amount. If you make an early withdrawal from your RRSP (before the age of 71), you may be subject to withholding tax at a higher rate.  The withholding tax rates for RRSP withdrawals can vary, generally being higher for larger amounts. There are specific programs, such as the Home Buyers' Plan, which allows you to take out up to $35,000 from your RRSP to purchase or construct a home. However, these withdrawn funds must be repaid within a specified timeframe. Another program, the Lifelong Learning Plan, permits annual withdrawals of up to $10,000 from your RRSP for education purposes for yourself, your spouse, or common-law partner. Similar to the Home Buyers' Plan, these amounts must also be repaid within a designated period. Once you reach the age of 72, you are required to convert your RRSP into a Registered Retirement Income Fund (RRIF) or use the funds to purchase an annuity. Withdrawals from a RRIF are subject to a minimum annual threshold, determined by factors such as your age and the value of your RRIF. These mandatory withdrawal amounts ensure that the funds are gradually dispersed over time, aligning with your retirement years.

Age Limits

• TFSA: There is no age restriction for TFSA contributions, allowing you to contribute at any age throughout your lifetime.
• RRSP: You can contribute to an RRSP until the end of the year in which you reach the age of 71. After this point, it is mandatory to either convert your RRSP into a Registered Retirement Income Fund (RRIF) or use the funds to acquire an annuity.

Both TFSA and RRSP offer distinct benefits and are frequently utilized together to fulfill various financial objectives. The choice between the two hinges on individual circumstances, financial goals, and tax planning strategies. Seeking advice from a financial advisor or tax professional is recommended to determine the most suitable approach tailored to your specific situation.

TFSA Basics

• The government sets an annual contribution limit, which is $6,500 for the year 2023. Eligibility for contributions applies to individuals aged 18 or older who are considered tax residents of Canada, even if they haven't filed their taxes.

• If you choose not to contribute to your RRSP in a particular year, you have the flexibility to make up for it in the following year. This means that in addition to the regular contribution limit for the new year, you can contribute the unused amount from the previous year. This carry-forward feature allows individuals to adapt their contributions based on their financial circumstances, providing a certain degree of flexibility in managing their RRSP contributions over time.

• For individuals who reached the age of 18 in 2009 or earlier, when Tax-Free Savings Accounts (TFSAs) were first introduced, and who have not yet opened a TFSA, their cumulative contribution room has now grown to $88,000. If you are younger, determine your maximum contribution by summing up the annual limits since the year you turned 18, as specified in the historical annual limits.
• To find your specific contribution limit, you can review your Notice of Assessment or access it by logging into your CRA My Account.
• Contributions to your TFSA are made with after-tax money, meaning you don't receive a tax deduction. However, you can withdraw both the contributed funds and any earnings they generate at any time without incurring taxes.
• When you make a withdrawal from your TFSA, your contribution room is reinstated as of January 1st of the immediate following year.

In summary, TFSA contribution limits are established annually by the government. Eligibility for contributions applies to individuals aged 18 or older who are tax residents in Canada. If you don't use your full contribution room in a given year, you can carry it forward to subsequent years.  To identify your precise contribution limit, refer to your Notice of Assessment or access the information via your CRA My Account. Contributions to a TFSA are made using after-tax dollars, and you have the flexibility to withdraw funds and their earnings tax-free at any time. When you make a withdrawal, your contribution room is replenished the following year.

RRSP Basics

• The maximum amount you can contribute to your registered retirement savings plan (RRSP) in a given year, known as your annual contribution limit or deduction limit, is calculated as a percentage of your income. Specifically, you can contribute up to 18% of your income for the year, but there is also an upper limit set by the government that caps the total allowable contribution. The government imposes these limits to regulate the amount of income that can receive tax deductions through contributions to RRSPs. For example, in 2023, this maximum limit is $30,780, which corresponds to 18% of an income of $171,000.
• Any unutilized contribution space can be carried forward over the subsequent years. You can go through your Notice of Assessment, or your NOA, for that matter, and figure out how much you can contribute by accessing your CRA My Account.
• These are the pre-tax contributions to your RRSP. When you when you contribute to your RRSP, it lowers the taxable income. They will be obliged to compensate for that specific year.
• There are only specific circumstances where you can borrow money from RRSP. Such examples include when you require money to fund eligible education expenses. For expenses or as a deposit on your own house.
• You may keep an RRSP active right up to December 31 of the year that you reach 71 years old. At this juncture a choice has to be made as to either liquidate the full funds amount which is a taxable affair or convert it to a RRIF/annuity. These alternatives provide the flexibility to spread out your retirement income over an extended period.
• Contributions to the RRSP are limited by your income, and they are deducted on a pretax basis. You can withdraw your savings for some specific reasons, but this process is not subject to immediate taxation. When you turn 71, you have to decide how you will handle the money in the RRSP. You will decide whether you want to convert them into a RRIF, get annuities, or withdraw totally.

How to choose between a TFSA or an RRSP?

People often get confused whether they should go for a TFSA or opt for an RRSP. Both have their own pros and cons. Here are 4 factors to consider when choosing between TFSA and an RRSP.

1. Clearly know your investment goals

The purpose of your savings plays a crucial role in determining which financial tool is most suitable for you. People typically save for various reasons, such as retirement, education, buying a house, or creating an emergency fund. When contemplating withdrawing the complete sum of your savings, a Tax-Free Savings Account (TFSA) is frequently favored. The reason behind this preference lies in the flexibility of a TFSA, as it allows you to access your funds whenever needed without incurring any tax consequences. Unlike other options, a TFSA provides a tax-free environment for your savings, allowing for easy and penalty-free withdrawals at any time. Nonetheless, when you're saving for specific objectives such as education expenses or buying your first home, you may consider using either a TFSA or a Registered Retirement Savings Plan (RRSP).

However, if you plan to use your RRSP to buy a house for educational purposes, then you need to understand how the tax laws work in regards to programs like the Home Buyer’s Plan or Lifelong Learning Program. These programs offer a structured approach to tap into your RRSP savings for these specific purposes while providing opportunities to repay the withdrawn amounts in the future. Make sure you understand the rules of each of these plans so that you can make an informed decision. These plans enable you to make withdrawals from your RRSP for these specific purposes under certain conditions.

Additionally, for those saving towards their first home, there's a new option called the First Home Savings Account (FHSA), which became available on April 1, 2023. In case you are planning to buy your first home, you should also consider exploring Tax-Free First Home Savings Account and its benefits that you can avail. Ultimately, the choice between TFSA and RRSP depends on your savings goals and the rules and advantages associated with each option.

2. Assess your current and future income

The government will eventually collect taxes on your savings; the key decision is whether you prefer to pay those taxes now or later.  Opting for a Tax-Free Savings Account (TFSA) entails paying taxes on the money being saved at the time of contribution. Conversely, if you select a Registered Retirement Savings Plan (RRSP), taxes are deferred until you make withdrawals in the future. The decision between TFSA and RRSP depends significantly on the amount of tax you will owe, influenced by your current and anticipated future tax brackets. Keep in mind that contributing to your RRSP may put you in a lower current taxable income slab which may reduce your taxes as well. However, when you eventually withdraw funds from your RRSP, it will increase your taxable income, potentially leading to higher taxes in the future. Your choice between RRSP and TFSA should be based on your current financial situation and your expected tax outlook.

If your current income is substantial, it is recommended that you make contributions to an RRSP, as this will result in considerable tax savings. However, if you anticipate having a higher income in the future, it's crucial to be aware that you'll be liable for higher taxes, and these taxes will apply to all your RRSP withdrawals, including both your contributions and any profits earned within the account. It's crucial to emphasize that your forthcoming taxable income includes all forms of income, extending beyond the funds held in your RRSP.

On the other hand, with a TFSA, you pay taxes upfront on the money you contribute, but the advantage is that, regardless of how much your TFSA earns through investments, you won't face additional taxation on those earnings in the future. In essence, a TFSA offers tax-free growth and withdrawals. Your choice between RRSP and TFSA depends on your current income level, expected future income, and your preference for immediate tax benefits versus tax-free withdrawals later on.

The general recommendation is to choose to pay taxes when you find yourself in a lower tax bracket, whether that's presently or down the road, depending on your personal circumstances.

3. Make a note of your financial habits

This means you need to understand how disciplined you are with money. When you see money in your account, is it hard for you to control the temptation to spend it, then a TFSA would be a great investment choice for you. This is because you're aware that when you withdraw money from your RRSP, you'll be required to pay taxes on that sum. On the other hand, if you opt for a TFSA, there will be no tax penalties upon making withdrawals.

4. Check your workplace for perks available

The principle of "Never decline free money" is a valuable guideline to keep in mind, particularly in your professional life. If your employer provides the opportunity to contribute additional funds to your RRSP or TFSA savings with an additional contribution from them, be sure to seize this opportunity. It's like getting extra cash for your investments, and it's easy because the money is usually taken out of your paycheck automatically. Understanding the mechanics of these supplementary contributions may impact your choice between an RRSP, a TFSA, or a combination of both.

TFSA or RRSP – which one makes more money?

TFSA and RRSP have a certain potential to generate income through investments and you should know about it. The key distinction centers on when and how income tax is levied on the funds within these accounts. It's crucial to recognize that TFSAs and RRSPs are not investments in and of themselves; rather, they are investment accounts that provide a platform for holding a variety of investment types. These investment options encompass cash in high-yield savings, stocks, bonds, or financial instruments such as mutual funds or exchange-traded funds (ETFs)

Whether a TFSA or an RRSP makes more money depends on a variety of factors like – your financial goals, your investment strategy, and your current financial situation. Here are some considerations to help you decide.

TFSA

• Tax-Free Growth: The funds invested within the TFSA are always free from any taxation, allowing investors to reap the full rewards of compound gains without any deductions. This means you won't pay tax when you withdraw funds.
• Flexibility: The flexibility of TFSA supports different purposes, including a quick contingency pool (emergency fund) and for ultimate long-term plans—like the future retirement.
• No Impact on Government Benefits: No one becomes ineligible for government benefits and tax credits upon withdrawal of funds from a TFSA.

However, TFSAs do not provide a tax deduction for contributions. Contributions are made with after-tax dollars, and the contribution room is limited each year.

RRSP

• Tax Deductions: Contributions to an RRSP are tax-deductible, reducing your taxable income for the year. This can lead to immediate tax savings.
• Ideal for Retirement: RRSP are tailor made to promote saving for retirement and help grow a sizeable fund for living after employment. The main objective of RRSPs is ensuring that people have a way in which they save money before and upon retirement. Contributions to an RRSP help individuals reduce their current year taxes towards making their life comfortable when they are old.
• Lower Taxes in Retirement: Within an RRSP, funds experience tax-deferred growth until they are withdrawn. This means that any investment gains, interest, or dividends earned within the RRSP are not taxed until you make withdrawals. In your retirement years, when you do withdraw funds from your RRSP, there's a possibility that your income could be in a lower tax bracket compared to your working years. This aspect can be advantageous, as it may result in a reduced tax liability on the withdrawn amount, potentially allowing for more tax-efficient income management during retirement. This situation can have the beneficial effect of reducing the amount of taxes owed on the withdrawals. Essentially, the idea is that as your income may decrease in retirement, the portion withdrawn from your retirement savings is taxed at a potentially lower rate, optimizing the tax efficiency of your withdrawals. This is a key consideration in retirement planning, allowing individuals to manage their finances strategically to minimize tax liabilities and make the most of their retirement income.

On the downside, RRSP withdrawals are fully taxable as income when withdrawn. If you need to withdraw funds for non-retirement purposes, it can result in higher taxes and potential clawbacks of government benefits.

While your investments and their earnings remain within your TFSA or RRSP account, they are not subject to taxation. This means that any returns you earn on these investments are not taxed while they are held within the account. Additionally, withdrawals from a TFSA are not taxable.

In contrast, regardless of whether you make a withdrawal from an RRSP today or in the future, the amount withdrawn is considered taxable income. Consequently, you are obligated to pay income tax on the withdrawn sum. The fundamental difference between the two accounts lies in the timing of income tax obligations.

RRSP contributions grant an immediate tax advantage since they reduce your taxable income in the year you contribute, enabling you to invest a more substantial amount upfront. The tax deferral advantage of RRSPs means that you postpone paying taxes on the contributed funds and their growth until you withdraw them, ideally when your overall income is lower, and thus, you may face a reduced tax burden. The timing of withdrawals becomes crucial in optimizing the tax efficiency of RRSPs and aligning with your financial situation, particularly during retirement.

With a TFSA, you pay income tax on your contributions upfront, using after-tax income. However, any future withdrawals from the TFSA, including both contributions and earnings, are entirely tax-free.

The decision between TFSA and RRSP hinges on your unique circumstances and the income tax rates relevant to each situation. Determining whether it is more beneficial to pay income tax immediately or defer it to a later time depends on factors such as your present tax bracket, anticipated future tax bracket, and your financial objectives. Ultimately, the decision should align with your long-term financial strategy and tax planning considerations.

As depicted in this chart, when the tax rates are equal, the final outcome remains identical.