The two most prominent investment accounts for Canadians are the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA).
Before taking a look at some of the similarities and differences, it is important to note one basic fundamental: RRSP’s and TFSA’s are not investments – they are accounts which hold the investment product. Prospects and clients often tell me they have a TFSA, and when asked what it is invested in, they reiterate that the investment is a TFSA. This is incorrect. The type of account (RRSP, TFSA, etc.) is not the investment; it is solely the vehicle that holds the investment (stocks, bonds, GIC’s, etc.).
- RRSP’s and TFSA’s are registered accounts, which means registered with the Canada Revenue Agency. This gives access to preferential tax-treatment (described below), compared to non-registered accounts.
- Investment growth accumulates on a tax-sheltered basis. This means that interest income and capital gains that are earned from the investments are not subject to annual tax reporting. A deferral of taxes means more capital is accessible for investing purposes, leading to a compounding effect.
- Contribution limits carry over on a year to year basis if unused. In other words, you do not “lose out” on contribution room in a TFSA or RRSP if you do not contribute in a year.
Income Tax Deductions (RRSP) – When someone makes an RRSP contribution, they receive a reduction in their taxable income, essentially meaning they will owe less income tax. For example, let’s say someone paid tax throughout the year on their $100,000 salary and proceeded to make a $10,000 RRSP contribution in the same year. They would now have taxable income of $90,000 for the year ($100k of earned income reduced by the $10k RRSP contribution). The end result is a roughly $3,000 reimbursement (tax return) based on the fact that the investor paid tax on $100k of income even though their net income for the year is effectively $90k. This is a simplistic example, but illustrates how effective RRSP contributions can be for income tax savings.
Income Tax Deductions (TFSA) – There is no corresponding reduction in taxable income when contributing to a TFSA.
Withdrawals (RRSP) – RRSP withdrawals are included in taxable income in the year the funds are withdrawn (there are a few exceptions to this with the Home Buyers Plan and Lifelong Learning Plan, which permit tax-deferred withdrawals under strict guidelines). RRSP’s are, as the name suggest, designed for retirement, so investors should not be accessing these funds prior or there will be tax repercussions. Additionally, the corresponding amount of RRSP room is permanently lost when funds are withdrawn.
Withdrawals (TFSA) – Withdrawals out of a TFSA are not included in taxable income when withdrawn. This provides added flexibility comparative to the RRSP. Furthermore, TFSA room is not lost when funds are taken out; it is regained the following year.
Contribution Room (RRSP) – Contribution room for RRSP’s are based on earned income. If someone never earns an income through employment or self-employment, they will not have RRSP room. Approximately 18% of earned income in a calendar year is added to an individual’s contribution room, up to a maximum of $27,230 for 2020. So, someone who earned $100,000 in a given year would acquire $18,000 in RRSP room. These balances can also be carried forward until a taxpayer turns 71. Note: a business owner paying themselves in dividends does not qualify as earned income for RRSP purposes. Dividends are viewed as investment income.
Contribution Room (TFSA) – The TFSA was implemented in 2009 and has undergone various changes in annual contribution room by the different governments in power. For 2020, the annual contribution limit is $6,000 and the year-over-year accumulated contribution room is $69,500. TFSA limits are not based on earned income; it is based off age and having a valid Canadian social insurance number.
Age Requirements (RRSP) – There is no minimum age that someone can have an RRSP, but they must have earned income in order to acquire contribution room. By December 31st of the year the individual turns 71 years of age, their RRSP must be converted to a Registered Retirement Income Fund (RRIF) or other specified payout vehicle.
Age Requirements (TFSA) – A TFSA can be opened and contributed to when someone reaches the age of majority. This is age 18 in some provinces and 19 in others. If someone was not the age of majority when the TFSA was introduced in 2009, they would not accumulate contribution room for that year. In other words, TFSA room is only contributed for the year someone is eligible. There are no rules pertaining to when a TFSA accountholder has to withdraw funds or convert the account.
On Death (RRSP) – Since withdrawals are included in taxable income, a deemed disposition on death can create a significant tax liability for an accountholder. Spouses and financially dependent children and grandchildren qualify for a rollover, meaning an RRSP can pass to one of these individuals on a tax-deferred basis. If there are no eligible beneficiaries to permit a rollover, the full amount of the RRSP would be included in income on their final tax return.
On Death (TFSA) – There are no major income tax implications as a result of a TFSA accountholder’s death. Beneficiaries or successor accountholders are permitted, which will impact how the TFSA gets taxed in their hands, but that is beyond the scope of this article.
Creditor Protection (RRSP) – RRSP’s are creditor protected, covered under Canada’s Bankruptcy and Insolvency Act. An exception to this is certain funds deposited in a 12-month period prior to bankruptcy, which can be viewed as “hiding” funds from looming creditors.
Creditor Protection (TFSA) – TFSA’s are not offered credit protection under Canada’s Bankruptcy and Insolvency Act. One exception to this is TFSA’s invested in an insurance product, such as a segregated fund, for which specific beneficiary designations will provide creditor protection.
Which is better?
So, after seeing the similarities and differences listed above, which should Canadians be using for their investments? There are different scenarios that I believe cater towards each account. For individuals who are saving for retirement and will not be accessing the investment account prior to said retirement, I recommend going with an RRSP. On the contrary, if the purpose of the investment account is saving for a specific expense or purchase, such as a wedding or property or vacation, then I recommend going with a TFSA. I refer to those situations as “saving to spend.”
Another factor to consider is marginal tax rates. If someone is in a low tax bracket but anticipates being in a higher tax bracket in future years, saving their RRSP contribution room for those later years is advisable from a tax perspective. Remember, RRSP contributions are tax deferrals; if someone is in a higher tax bracket when they withdraw compared to when they contributed, they are not coming out ahead tax wise.
As evidenced above, there are different situations that will impact the most suitable registered account to hold your investments (a mix of both the TFSA and RRSP is often recommended). Investing should be done holistically, factoring in age, income, experience, risk tolerance, income projections and current and future tax rates; as a Certified Financial Planner, that is something I specialize in. Reach out if you have questions, I can be reached at 604-761-7543 or firstname.lastname@example.org.