When it comes to saving, the TFSA vs RRSP debate is always at the forefront. Many people are confused as to whether to choose the Registered Retirement Savings Plan (RRSP), Tax-Free Savings Account (TFSA) or a combo of both to put money away for the future. Regardless of whether you choose the RRSP or TFSA (or make use of both!), one of the best things you can do is invest consistently. Which is why I recommend using a pre-authorized contribution plan to your discount brokerage account or setting up a pre-authorized “set it and forget it” investment solution with one of Canada's robo advisors to pay yourself first.” Over time, you can gradually increase your contributions until you max out both accounts.
Both the TFSA and RRSP are investment vehicles that reduce taxes on investment income but depending on your circumstances, one might better for your money than the other. The TFSA is more flexible and offers a better tax benefit than the RRSP, but doesn’t have as high contribution room. The RRSP will probably let you set aside more, but has stricter rules around when you can withdraw your money, and what for.
Main Difference Between RRSP and TFSA
The main difference between the RRSP and TFSA is how your income is taxed when you contribute or withdraw from each account. The RRSP is a tax-deferred account, which means you contribute to it with pre-tax incomes and you’ll pay your income taxes on your withdrawals. In contrast, the TFSA is a tax-free account – meaning you contribute to it with after-tax income, so you’ll pay no more income taxes when you make a withdrawal. Because of this tax structure, you should come out with about the same amount of money whether you choose the RRSP or TFSA, which is why you shouldn’t sweat your TFSA vs RRSP decision too much.
For example, here’s what happens when you compare putting your earned income in a TFSA vs RRSP:
|Gross earned income||$1,000||$1,000|
|Income tax (30%)||$300||$0|
|Value after 30 years at 6%||$4,020||$5,743|
|Income tax at withdrawal (30%)||$0||$1,723|
Keep in mind the above table makes a few assumptions, namely that if you claim your RRSP contribution at tax time to get a refund, you deposit that refund into your RRSP. If you make RRSP contributions and claim them when you file your tax income but don't use the tax benefit to further top up your investment, the calculations won't be the same. Likewise, the calculations assume you know what your marginal tax rate will be during retirement, which if you’re in your 20’s or 30’s, is difficult to predict!
TFSA vs RRSP Comparison
Despite their names, neither the RRSP or TFSA have to be a savings account. You can and should hold a variety of investments in your accounts such as GICs, mutual funds, stocks, bonds, and ETFs. Both of these accounts should be more appropriately named “Tax-Free Investment Account” and “Registered Retirement Investment Plan” because investing is really the best way to unlock the power for these accounts.
The real difference between the RRSP and TFSA come down to their contribution limits and withdrawal restrictions, as well as how and when you pay taxes at these events.
Pros of the TFSA:
- You can have your money managed through robo advisor like Questwealth Portfolios and BMO SmartFolio.
- The TFSA is a very flexible savings tool that allows you to contribute and withdraw from a tax-sheltered account easily and without penalty.
- TFSA investments have already been taxed, so unlike your RRSP investments, you can safely determine exactly how much money you can take out when you retire.
- When you retire and start pulling money out of your RRSP and TFSA accounts, as well as collect government payments such as Old Age Security (OAS), the government takes your RRSP withdrawals into consideration when “clawing back” your OAS – but this is not the case when withdrawing from TFSA.
- Just like the RRSP, your investments can compound inside your TFSA tax-free (this can make a HUGE difference if you start at a young enough age).
The TFSA Lowdown
The RRSP was introduced in 2009 to give Canadians a more flexible savings tool. Like the RRSP, the TFSA is best used for retirement savings. However, unlike the RRSP, the TFSA can also be used for anything else!
- You can open a TFSA as soon as you turn 18.
- As of 2019, you can contribute up to $6,000 per year to a TFSA. TFSA contribution room is indexed to general inflation, so over time, it has varied from $5,000 and even was briefly $10,000 for one year. This contribution room doesn't disappear if you don't use it but is carried forward to future years when you can catch up.
- As of 2019, if you haven’t opened a TFSA before, you can contribute up to $63,500!
- Like an RRSP, you can hold a number of things within the TFSA. The TFSA is like a basket that you put investments into (GIC's, High-Interest Savings Accounts, stocks, bonds etc.).
- Money contributed to TFSAs is done with after-tax income so you don’t get a tax refund for contributions.
- You can withdraw money from your TFSA at any time for any reason, completely tax-free.
- When you make withdrawals from your TFSA, the contribution room is returned the following calendar year. For example, if you have maxed out your TFSA contribution, then you withdraw $2,000, you can’t put $2,000 back into your account later in the year unless you want to pay a penalty (known as a TFSA over-contribution). Instead, you will get the $2,000 in contribution room added on to your contribution room the following year, so in 2020 your contribution room will be $8,000.
- The TFSA is best used for investing rather than saving. If you use the TFSA to invest in long-term equities, you can shelter a substantial amount of investment earnings in your TFSA. Would you rather shelter the 1% you are getting in a high-interest savings account or the 7-8% a balanced index ETF portfolio could snag you?
Pros of the RRSP
- RRSPs are perfect for holding stocks and ETFs from the USA. This is because of a tax treaty that Canada and the USA have when it comes to taxation of dividends. It can get kind of complicated (if you want the in-depth explanation, here’s a good place to start), but the short story is that RRSPs are a great place to park US-based equities.
- You can DIY with an online brokerage like Questrade, if you're a savvy investor, or have your money managed through a robo advisor like Wealthsimple.
- It feels awesome to get that tax return. Especially when you use that tax return to supercharge your RRSP contributions for the following year.
- RRSP withdrawal restrictions force you to be more responsible because of the tax hit you will take if you withdraw the money for something other than the First-Time Homebuyer’s Plan, Lifelong Learning Plan, or retirement. We’re all human, and if we know that money is accessible then it’s hard to keep sticky fingers away from the cookie jar! Consequently, using an RRSP is a great way to develop disciplined investing habits.
- The RRSP is an especially good tool for those with high incomes in a high tax bracket. It can feel good to get some of your tax dollars back and then defer your investment returns until you retire to a lower tax bracket.
The Basic Lowdown on the RRSP
The RRSP was introduced in 1957 to help Canadians save for retirement.
- The RRSP can hold a number of different investments including GICs, mutual funds, stocks, bonds, and ETFs
- Contributing to the RRSP is done with pre-tax income (the tax refund you receive for claiming your contributions at tax time is your pre-tax money returned to you at a later date).
- You will have to pay tax when you make a withdrawal. The hope is that when you take money out of the RRSP, you’ll be at a lower income than when you put money in because you’ll be retired, so your average tax rate will also be lower.
- Your maximum RRSP contribution is calculated by calculating 18% of your gross income or $26,230 (as of 2018), whichever is lower. Any unused contribution room can be carried forward to the next year.
- There are two options that let you withdraw money from your RRSP for purposes other than retirement. However, for both of these, you are merely borrowing from yourself and will need to repay the amount:
- Home Buyers Plan (withdraw up to $25,000 for a down-payment on your first home, and repay over 15 years)
- Lifelong Learning Plan ($10,000 per year to a maximum $20,000 for school, and repay over 10 years)
Cons of the TFSA:
- There is a lot of confusion about how to maximize the power of the TFSA. TFSAs are being heavily marketed as savings accounts, so most people don’t know they can use it to invest!
- TFSAs have a low contribution limit compared to the RRSP. The majority of Canadians still earn significantly more during their working years than they do in retirement. This usually tips the balance in favour of RRSP contributions.
- Because it’s so easy to take money out of a flexible account such as the TFSA, human nature might tempt you into making decisions that are not conducive to building long-term wealth. Many people use their TFSA for vacation savings or an emergency fund, which wastes the tax-sheltering power of this account.
- Some employers only offer pension-match contributions for RRSP contributions. If this is the case – then ignore everything else – take the free money your employer is offering!
Cons of the RRSP
- If you’re fortunate to have a great pension, you will be taxed to the nines when you are in retirement, especially when you are forced to take your RRSP out when you turn 71 via the Registered Retirement Income Fund (RRIF). Some people end up paying an even higher tax rate than they would have during their early working years.
- You can’t take money out penalty-free except for buying your first home or under the Lifelong Learning Plan.
- If you aren’t making much money in a given year (e.g. if you are a student), there isn’t too much point in taking a deduction and chasing a big tax refund via an RRSP contribution. You already aren’t taxed very highly (if at all), so you won’t get much of your taxes paid back.
- If you don’t re-invest your tax refund, then you lose out on the pre-tax advantages. Most Canadians gloss over this little detail.
Invest in an RRSP or TFSA?
I can’t emphasize this enough: to really supercharge your RRSP or TFSA, make sure to open an investment account. Do not be fooled by the word “saving” in either name – these are investment accounts!
If you’re confident managing your own portfolio, you can choose an online brokerage like Questrade. If you’re brand new to the stock market, or simply want to let someone else do the hard work, choose a robo advisor like Wealthsimple or BMO Smartfolio.
To summarize, you should have both a TFSA and an RRSP (and be investing in both!). The TFSA makes sense for virtually everyone, but the RRSP becomes increasingly relevant if you’re at a high income or your TFSA is maxed out. Now go forth and prosper!
Editor's note: This article was originally published in 2017 and has been updated to represent the current changes in 2019.