RRSP vs. TFSA: What should I choose?

Not sure whether to select an RRSP, a TFSA or both? It’s a very common question that arises, as many Canadians don’t know the difference between the two types of investment accounts.

Essentially, both the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA) have certain income tax benefits. TFSA lets you shelter tax on investment returns, while RRSP allows you to defer tax until withdrawal later on. Both of these accounts have their pros and cons, and whether you choose an RRSP, a TFSA — or in many cases both — depends on your needs and circumstances.

Before you open a RRSP, TFSA or both, here’s a breakdown of how RRSPs and TFSAs work, how they differ from each other, and how each could best match your goals.

An RRSP is an account intended to help you save for retirement, and the contributions made result in immediate income tax deductions in the year you contribute.  One of the main benefits of an RRSP is that you defer paying taxes on the money you put in today and any investment income earned, until years later when you withdraw your money in retirement. When you’re retired, you could potentially be in a lower tax bracket and pay fewer taxes than when you are making a larger income.

TFSA is a relatively new investment vehicle that was introduced in 2009. It can be used to save towards retirement, but also many other goals because, unlike an RRSP, you’re free to withdraw at any time without penalties. The main benefit of a TFSA is that they are completely tax free. Since you’ve already been taxed on the money you put into your TFSA, any income you earn from the investments within your TFSA is completely tax free, even when you withdraw from it.

Each of these accounts offer valuable benefits so with a bit of planning, you can take advantage of both.

The money you put into your RRSP is mainly meant for your retirement. The account allows you to avoid paying income tax on it now, which helps reduce your current income tax bill. 

By the end of the year that you turn 71, you'll have to convert your RRSP to a RRIF (registered retirement income fund). This fund will give you regular payments, like a salary. At that point, you'll pay tax on this money, but the idea is that as a retired person, you'll be in a lower tax bracket than you would have been when you were working so that you pay less tax on the income earned.

RRSPs are built for long-term investment, so withdrawals are a bit more complicated than with TFSAs, and, unless you're taking out money in the Home Buyer's Plan (HBP) and Lifelong Learning Plan (LLP), you'll have to pay tax. (More about these programs below.)

TFSAs are more flexible than RRSPs, and the money you invest can grow entirely tax-free. You've already paid taxes on the funds you deposit so you can withdraw the principal and any earnings at any time and for any purpose without having to pay taxes. This makes TFSAs more flexible than RRSPs, and the perfect option if you've maxed out your RRSP contribution room for the year.

Generally, the same types of investments are permitted in both. There are a wide variety of options to choose from including cash, guaranteed investment certificates (GICs), exchange-traded funds (ETFs), mutual funds, stocks and bonds.

You must be 18 years of age or must have reached the age of majority in your province and be tax resident of Canada, to open a TFSA and make a contribution. . However, for an RRSP, you can open and contribute as soon as you start earning income.

In order to contribute to an RRSP or a TFSA you need a Social Insurance Number.

You can withdraw money from your RRSP at any time but it will be subject to withholding and will also be taxed as income.

RRSP withdrawals are usually taxed as income. But there are two exceptions:

• The Home Buyer’s Plan (HBP): The HBP allows you to borrow up to $60,000 tax-free from your account that you can put towards your first home. You have 15 years to pay it back without any penalty.
• Lifelong Learning Plan (LLP): The LLP allows you to borrow $10,000 a year to help pay for your education. You have 10 years to pay back this amount without any penalty. You can also use the LLP for your spouse’s education, but not for your children.

You can withdraw from your TFSA anytime, depending on the type of investment, without being taxed. An important rule to be aware of when withdrawing from your TFSA, is that making a withdrawal doesn’t result in loss of your lifetime contribution room. Withdrawals you make will be added to your unused contribution room the following year. Next year, you can contribute next year’s limit plus the amount you withdrew this year.

RRSP contributions can be made up to and including Dec 31 in the year when you turn 71 or in the case of spousal RRSP up to the year when your spouse turns 71.

For a TFSA account, you must be at least 18 years of age, but you can continue investing as long as you want.

The over contributions towards TFSA will be subject to a penalty of 1% per month. This is only on the over-contribution amount.

For an RRSP account, you can exceed the contribution limit by $2,000 without penalty after which a penalty of 1% per month will apply.

Another important factor to keep in mind is how your income and goals can affect the investments you choose. For example, those in a lower tax bracket may benefit less from the tax savings an RRSP provides and could be better off contributing to a TFSA now. However, if income rises in future years, you may want to start contributing to an RRSP.

You might choose one plan over the other or choose to contribute to both, but as your income increases or if there are significant changes in your life then you will have to tweak the strategy and contributions to get the most bang for your buck.