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Not sure whether to open an RRSP, a TFSA or both? This is a common question among Canadians.
Both the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA) have certain income tax benefits that differentiate one from the other. An RRSP allows you to defer tax until withdrawal later on, while a TFSA lets you shelter tax on investment returns. These accounts each have pros and cons, so whether you choose an RRSP, a TFSA — or often, both — depends on your needs and circumstances.
Before you decide which route is best for you, here’s a breakdown of how RRSPs and TFSAs work, how they differ 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 is that you defer paying taxes on the money you put in and any investment income earned until years later when you withdraw your money in retirement. When you're retired, you’d potentially be in a lower tax bracket and pay fewer taxes than when you were making a larger income.
A TFSA is a relatively new type of investment account introduced in 2009. It can also be used to save towards retirement or for more immediate goals because, unlike an RRSP, you’re free to withdraw money at any time without penalties. The main benefit of a TFSA is that it’s 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 not taxed, even when you withdraw from it.
Each account offers valuable benefits, so with some planning, you can take advantage of both.
The money you put into your RRSP is mainly meant for your retirement. This account allows you to avoid paying income tax 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 you ultimately 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 Buyers’ 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 paying 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 investments are permitted in both. There are a 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 old or must have reached the age of majority in your province and be a 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 an income.
In order to contribute to an RRSP or a TFSA, you need a Social Insurance Number (SIN).
You can withdraw money from your RRSP at any time, but it will be subject to withholding tax and also be taxed as income.
RRSP withdrawals are usually taxed as income. But there are two exceptions:
- The Home Buyers’ Plan (HBP): The HBP allows you to borrow up to $60,000 tax-free from your account to 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 at any time without being taxed, depending on the type of investment. An important rule to be aware of is that withdrawing from your TFSA doesn’t result in loss of your lifetime contribution room. Withdrawals you make will be added to your unused contribution room the following year, which means you can contribute next year’s limit plus the amount you withdrew this year.
Is there an age limit to make contributions?
RRSP contributions can be made up to and including December 31 of the year you turn 71 years old, or in the case of a spousal RRSP, up to the year your spouse turns 71 years old.
For a TFSA account, you must be at least 18 years old, but you can continue investing as long as you want.
The amount you over-contribute towards a 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.
Keep in mind
Your income and goals may affect the investments you choose. For example, those in a lower tax bracket may benefit less from an RRSP's tax savings and could be better off contributing to a TFSA. However, if your income increases in the future, you may want to start contributing to an RRSP.
You may choose one plan over the other or decide to contribute to both, but as your income increases or your life changes significantly, you will want to tweak the strategy and contributions to get the most bang for your buck.
