There are two prominent investment accounts for Canadians. They are the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA).
Before comparing the RRSP and TFSA for their 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 they’ve 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.).
Comparing the RRSP and TFSA:
- 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 you earn 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, and 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.
RRSP withdrawals are taxable income in the year you withdraw the funds. 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 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 you withdraw the funds.
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 you take out the funds; you’ll regain it the following year.
Contribution Room (RRSP)
The government bases the contribution room for RRSP’s on earned income. If someone never earns an income through employment or self-employment, they will not have RRSP room. In a calendar year, they’ll add approximately 18% of earned income to an individual’s contribution room. This will be 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. Until a taxpayer turns 71, these balances can also be carried forward. Note: a business owner paying themselves in dividends does not qualify as earned income for RRSP purposes. Dividends are investment income.
Contribution Room (TFSA)
Since they implemented the TFSA in 2009, it has undergone various changes in annual contribution room. 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; rather 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 to have any contribution room. By December 31st of the year the individual turns 71 years of age, they must convert the RRSP to a Registered Retirement Income Fund (RRIF) or other specified payout vehicle.
Age Requirements (TFSA)
You can open a TFSA and contribute to it when you reach the age of majority. This is age 18 in some provinces and 19 in others. If someone was not the age of majority when they introduced the TFSA 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 around when a TFSA accountholder has to withdraw funds or convert the account.
On Death (RRSP)
Since withdrawals are taxable income, a deemed disposition on death can create a significant tax liability for an accountholder. Spouses, children and grandchildren that are financially dependent qualify for a rollover. That means that 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 is 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. You can have beneficiaries or successor account holders, 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 before bankruptcy. They may see this 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?
After comparing the RRSP and TFSA, which should Canadians be using for their investments? There are different scenarios that cater towards each account. For people who are saving for retirement and will not be accessing the investment account, I recommend an RRSP. If the purpose of the account is saving for a specific expense or purchase (such as a wedding, property or vacation), then I recommend a TFSA. I refer to those situations as “saving to spend.”
Another factor to consider is marginal tax rates. If you’re in a low tax bracket and anticipate being in a higher tax bracket in future years, saving their RRSP contribution room for those later years is advisable. 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.
Every situation is unique and a mix of both the TFSA and RRSP is often recommended. My recommendation is to invest holistically. When comparing the RRSP and TFSA, you factor in age, income, experience, risk tolerance, income projections as well as current and future tax rates. As a Certified Financial Planner, that is something I specialize in. Reach out if you have questions.