Blog - April 21, 2023
A common question we get is, “What’s the difference between an RRSP and TFSA?” If you’re interested in the basics, keep reading, we’ll give a brief overview of what they are and include a few scenarios of where one might work over the other.
A registered retirement savings plan (RRSP) is an account that Canadians can contribute each year – these contributions reduce your taxable income in the tax year you make them. The money you contribute and any money you make inside your RRSP will become taxable income upon withdrawing. The expectation is that when you retire, you will be in a lower tax bracket, so in your retirement years, you start drawing from the RRSP and pay less tax overall.
A tax-free savings account (TFSA) is a registered account Canadians can contribute to with an annual limit of $6600 and lifetime maximum based on the annual amount. Money contributed to a TFSA is contributed into the account with after-tax dollars. The “tax free” in TFSA means that the money earned in the account is tax-free for as long as it’s in that TFSA and when you pull the money out, it also comes out tax-free.
Both a TFSA and an RRSP Can be Useful
If your tax rate is going to be higher when you pull money out than it is today, then you may want money to go into your TFSA because you’re getting taxed today while your tax rate is lower, and you’re pulling the money out tax-free in the future when your tax rate is high.
Suppose your tax rate’s higher today than you expect it to be when you anticipate pulling money out; then your RRSP is going to win. To recap, when you contribute to an RRSP, you reduce taxes today in the belief you will be in a lower tax bracket in retirement. You get taxed on that money in the future when you pull the money out, and your tax rate is lower.
A Scenario for the Younger Generation
Let’s say your child starts their first job after graduation from college or university. Contributing to an RRSP right away likely wouldn’t be the best vehicle for those funds. Their tax liability will likely be relatively small, probably the smallest it will ever be, and we only have so much RRSP room.
When you’re young, getting started, and want to start saving by setting up an RRSP, it’s a great mindset to want to save, but a better option may be to contribute to a TFSA and save that RRSP room for a more significant tax year.
TFSAs Offer Flexibility
Say you’re saving for a trip or home renos; the TFSA may be superior because it provides flexibility. You can take money out of a TSFA anytime you want, tax-free, and you have the option to contribute the same amount back in the next calendar year. If you need money temporarily, you can take it out, put it back in six, nine, or 12 months later, and you haven’t lost any of your TFSA contribution room.
A Common Misconception: “I can’t get money out of an RRSP.”
Let’s clarify. You can also take money out of an RRSP anytime, with the caveat that it will be taxable when you pull it out and you will not regain the contribution room.
Here are a few scenarios where that may not be a big deal.
Say you just lost your job, and no earned income is coming in; RRSPs are available to get you over the hump. Maybe you’re on maternity leave, not bringing in a paycheque; you’re in a lower tax bracket and need some funds as a buffer.
Remember, it’s taxable and you can’t replace it once that money comes out. You don’t get the contribution room back. If you have contribution room, you can put more money in, but if you don’t have a contribution room, that amount of money that you pull out can’t go back into your RRSP.
Scenarios Where an RRSP May be a Better Option
When you’re in your peak earning years — at the top of your profession, and you’re taking a look at your career path, thinking, “Now this is probably the best money I’m going to make,” that’s when you’re probably most likely to find that an RRSP is the better option of the two. Or if there is a windfall, if you’ve just sold a property, or had some other taxable event.
Once you get into retirement, in many cases, your tax burden drops noticeably compared to your tax burden while you’re working.
To recap, the differentiating factor between RRSPs and TFSAs is the tax treatment when money goes in and comes out. TFSAs do not provide an upfront tax reduction; any withdrawals, including growth, are tax-free. You can have as many RRSPs and TFSA accounts as you have the patience to open. There’s no limit to the number of accounts, but a very tight limit is kept on how much money you can contribute, and it’s tracked with your social insurance number — if you over-contribute to a TFSA or an RRSP, the penalties can be significant, so you want to keep a close eye on it.
Those are the basics, but of course, there are nuances to your unique situation. Check out Episode 71 of Barenaked Money: RRSP vs TFSA to learn more.
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