Should you put money into your TFSA or RRSP? For Canadians, it’s an endless debate.
It can be as subjective as arguing which is better, Coke or Pepsi? Both are similar products, yet so different!
The dilemma is perfectly understandable. After all, until the TFSA came along, Canadians had always used their RRSPs to meet their long-term financial goals.
Both account types offer some tax advantages and allow you to save, but the way they function is very distinct from one other.
I will take a deep dive into both account types in this TFSA vs. RRSP post. Understanding these investment vehicles will help you determine when to use one over the other, or when to use both to achieve your financial goals.
What Is a TFSA?
The TFSA was first introduced to Canadians in 2009, and it has become very popular in recent years. Each year, the Canada Revenue Agency (CRA) allows additional contribution room for TFSAs. It means that you can contribute the additional amount for that year, plus any rollover contribution room from previous years.
Assuming that you were 18 in 2009 when the account was introduced, you will have a cumulative contribution room of $75,500. The CRA adds an average of $6,000 contribution room each year, adjusted to inflation.
When you contribute to your TFSA, the money you deposit is already taxed. You contribute from your net income, and there is no tax break at the time of contribution.
However, any gains you earn in a TFSA, whether in the form of a cash savings account or any investment product, will not be subject to capital gains or income tax. It means that you will not owe any tax on your earnings when you withdraw from your TFSA.
What Is an RRSP?
RRSPs have been around for far longer than TFSAs. Introduced in 1957, RRSPs allow you to contribute up to 18% per year of your gross income or $27,830 for 2021, depending on which amount is lower, without paying any income tax on that money.
If you contribute to your RRSP with after-tax dollars, the Canada Revenue Agency (CRA) will refund you the tax after you file your income tax for that contribution year. This tax-sheltered structure allows you to defer your taxes while you save for your retirement. An essential aspect to remember is that you will need to pay tax on it when you withdraw your money.
The basic idea is that you will likely be in a lower tax bracket in your retirement than you were during your years earning active income. Theoretically, you will end up paying much lower taxes overall by investing in an RRSP.
TFSA vs. RRSP – A Comparison
Both accounts have “savings” in their names, but they can be so much more than simple cash savings accounts.
While you can contribute cash to these accounts, you can also use your contribution room to hold various investments, including equity securities, Guaranteed Income Certificates (GICs), mutual funds, exchange-traded funds (ETFs), bonds, and other fixed-income securities.
Therefore, both accounts should be named investment accounts. Using them as investment vehicles is what allows you to get the best out of TFSAs and RRSPs.
The crucial difference between the two comes down to their respective contribution limits, restrictions on withdrawals, and how and when you pay taxes for withdrawals and contributions.
In the table below, I have summarized some of the advantages and disadvantages of both account types to give you a head-to-head comparison in each respect.
|Flexibility||You can withdraw amounts tax-free and use them for anything.||You cannot withdraw money penalty-free unless you purchase your first home or through the Lifelong Learning Plan.|
|Investment Options||You can choose your own investments.||You can choose your own investments.|
|Tax Rules on Growth||Tax-sheltered growth on investments.||Tax-sheltered growth on investments.|
|Direct Contributions||You can contribute directly up to $75,500 after the 2021 contribution room update.||You can contribute directly up to 18% of the previous year’s income or $27,830 for 2021, whichever is lower.|
|Tax Deductions||Contributions are not tax-deductible.||You can claim a tax deduction on your contributions during the year of contribution or carry it forward to future years.|
|Withdrawal Rules||You can withdraw any amount from your account at any time without paying taxes. Whether you withdraw some amount or completely withdraw the entire amount, it is tax-free. You get the contribution room back for the amount you withdraw in the next year. You can replace the withdrawn amount in the same year only if you have available contribution room.||You can withdraw any amount at any time from the account, but you would have to pay income tax on it. When you cash out of your account, you will have to pay income tax on the entire amount.|
|Contribution Limits||The annual maximum contribution limit varies year to year.The annual contribution limit for 2021 is $6,000.||The annual maximum contribution room is 18% of the previous year’s earned income or $27,830 for 2021, depending on which is lower.|
|Expiration Date||There is no expiry date.||You must convert your RRSP into a Registered Retirement Income Fund (RRIF) by December 31 of the year you turn 71 years old.|
The Primary Difference Between The TFSA and RRSP
The tax structure makes it possible for you to save the same amount of money if you remain invested in your accounts for the same time. This may make the TFSA vs. RRSP debate seem unnecessary.
Let’s take a look at an example to understand this better. Here is what happens when you compare putting $1,000 of your earned income in a TFSA vs. RRSP.
The income tax rate is 30% when you deposit the amount. It remains the same by the time you withdraw the amount, and you can expect a rate of 6% annual growth. Here is what your contributions would look like in 40 years.
|Income tax (30%)||$300||$0|
|Value after 40 years||$7,200||$10,285|
|Income tax at withdrawal (30%)||$0||$3,085|
|Net Amount After Withdrawal||$7,200||$7,200|
As a reminder, the example above makes many assumptions to create a similar situation for both cases. One such assumption is that if you claim your RRSP contribution during tax season to get a refund, you deposited that refund into your RRSP.
But suppose you do something else with the money instead of using the tax benefit to top up your investment. This will make the calculations far different.
Similarly, the calculations assume that the marginal tax rate will be the same when you deposited the amounts and withdraw the amounts. However, it is impossible to predict whether the marginal tax rates will be the same at these times.
Let’s take another example in which we have similar circumstances, but the marginal tax rate at the time of withdrawal is less than the marginal tax rate when you contributed to the accounts.
|Income tax (30%)||$300||$0|
|Value after 40 years||$7,200||$10,285|
|Income tax at withdrawal (25%)||$0||$2,571|
|Net Amount After Withdrawal||$7,200||$7,714|
In the scenario above, the RRSP offers a clear advantage with a lower marginal tax rate.
Let’s suppose that the marginal tax rate is higher at the time of withdrawal than the tax rate when you contributed to both accounts.
|Income tax (30%)||$300||$0|
|Value after 40 years||$7,200||$10,285|
|Income tax at withdrawal (35%)||$0||$3,599|
|Net Amount After Withdrawal||$7,200||$6,686|
In this case, the TFSA has a clear advantage over the RRSP.
Remember that any examples you see on the internet, including these, are based on a set of assumptions to explain how they might compare. It is crucial to apply the process to your specific circumstances using assumptions that you think are more suitable for you.
TFSA vs. RRSP 2021 – Which Is Better? Six FAQ’s
Both investment vehicles allow you to save on taxes and grow your wealth. Deciding which one is better will depend on your financial situation and goals.
When you use a TFSA, you can pay taxes on the money you have earned before contributing. With an RRSP, you get the tax refund on the money you contribute right now. But you will need to pay the tax later when you withdraw your money from the plan.
This key difference in the taxes, along with your income, investment horizon, and several other factors, will help you make a more suitable decision on how to invest your money. You might even find it practical to use both investment vehicles at the same time to achieve different financial goals.
1) TFSA vs. RRSP – Which is better based on your income and tax bracket?
Your annual income determines which tax bracket you fall in (i.e., the amount of income tax you have to pay). Both of these factors will have a major influence on which investment vehicle works better for you.
The general rule of thumb is that someone earning over $50,000 per year might find it better to invest in an RRSP. The money you put into your RRSP is tax-deductible, and your tax deductions can effectively result in immediate tax savings.
If you earn less than $50,000, the tax deduction might not be worth much because you are not likely to owe much income tax after claiming all the available tax credits. It would make more sense to put your money into a TFSA first with a lower income.
2) TFSA vs. RRSP – Which is better based on your investment time horizon?
When you invest, it is a good idea to know why you are saving that money. You can have a wide range of short-, medium-, and long-term financial goals. For instance, saving money and investing it to create a retirement nest egg will have a longer investment horizon than saving to purchase a car.
The RRSP was designed as an investment vehicle for your retirement. When you withdraw money from your RRSP in your retirement, you will likely generate much less income. It means that you will fall into a lower tax bracket than before your retirement and pay lower taxes in your lifetime.
The RRSP structure works well for retirement savings, but it does not work well with short- or medium-term financial goals. A TFSA allows you to make withdrawals anytime without incurring taxes or penalties.
This is why the TFSA might work much better for short- and medium-term investment horizons. You can achieve several small- and medium-term goals by using your TFSA. You can invest and save in your TFSA to buy a car and withdraw the amount when you have enough without any taxes.
3) TFSA vs. RRSP – Which is better in a group plan?
Group RRSPs that offer matching contributions from your employer, or a similar tax-deferred account like a Defined Contribution (DC) pension plan, might be a much better investment than TFSA.
Employer contributions tend to work like this: your employer matches a percentage of your salary when you invest the same percentage, or a percentage of your contribution, to your account. This is free money that you get for contributing to your account. You can’t get the same kind of returns by investing in any securities.
Let’s consider an example here:
An employer matching just 4% on your income of $75,000 will add an extra $3,000 to your RRSP. Additionally, your employer’s portion of the contribution might also count towards your RRSP deduction for tax purposes. Therefore, you are effectively going to receive a double benefit.
There are no such group plans available with TFSAs, making group RRSPs more favorable. However, it might not be ideal if the matching percentage is too low or the investment options are not good enough.
4) TFSA vs. RRSP – Which is better for buying your first home or saving for education funds?
The RRSP was designed to help Canadians save enough for a comfortable retired life. However, it has two caveats in the form of the Home Buyers’ Plan (HBP) and the Lifelong Learning Plan (LLP).
The HBP allows qualifying home-buyers to withdraw up to $35,000 from their RRSP so they can contribute to the purchase amount of their home. This is one of the two instances when you can make a tax-free withdrawal from your RRSP. However, you must repay the amount within 15 years.
The HBP is an excellent way to access a substantial amount of money, but it does effectively work like an interest-free loan that you have to return.
On the other hand, the LLP allows you to use your RRSP funds to contribute to you or your spouse’s full-time education or training. You can take out up to $20,000 for this purpose over two years, but you need to repay the amount within ten years.
When you are using a TFSA, you will not be limited to conditions or be required to pay back the amount you withdraw within a limited timeframe. So, the TFSA can be much better for both these purposes, provided that you can stick to your goals and not give in to the temptation to take out the money because of tax-free withdrawals.
5) TFSA vs. RRSP – Which is better as a retiree?
Withdrawals from your TFSA will always be tax-free, regardless of whether you are working or retired. Meanwhile, any withdrawals from your RRSP will result in taxes.
As a retiree, it might fare better for you to use both account types to maximize your tax savings and investment income.
You will likely be in a lower tax bracket when you retire than you were before your retirement. Hence, your RRSP withdrawals will incur taxes at lower rates than when you earned the money you contributed to the account. If you have a tax refund, you can maximize it by reinvesting the balance you receive in a TFSA.
With an RRSP, you will be forced to convert it into an RRIF on December 31 of the year you turn 71 years old. In comparison, a TFSA does not come with an expiry date, and you can continue enjoying tax-free returns from investments in that account even long after you retire.
6) Should I have both RRSP and TSFA?
Ideally, you should have a TFSA and an RRSP. The TFSA makes more sense for virtually everyone, but the RRSP becomes much more attractive as you earn higher income or when you have maxed out your TFSA contribution room. If the goal is to achieve financial security, using both accounts can be far more practical than sticking to one.
How to Use Your TFSA or RRSP
TFSAs and RRSPs are best used if you are investing with the accounts instead of holding cash. If you use the TFSA or RRSP to invest in long-term securities that offer higher returns than interest rates, you can accumulate a significant amount of tax-sheltered earnings.
High-interest savings accounts typically currently offer aound 1-2% interest rates. So, would you rather see your money grow by 2% for 30 years, or would you use a balanced index ETF portfolio that gives you 6%-8% returns at the same time?
Investing in different types of assets using your TFSA or RRSP is much easier today due to the advent of online financial firms that offer you low-cost alternatives to traditional financial institutions. You have several options to explore if you want to invest in securities through a TFSA or RRSP:
- If you are looking for a hands-off approach to investing with low fees and some guidance, you can consider opening a TFSA or RRSP investing account with a robo-advisor. There are several robo-advisor products available in Canada. Check out my list of the best robo-advisors in Canada to learn more.
- If you are a savvier investor interested in self-directed investing, you can easily open a TFSA or RRSP investing account with an online discount brokerage that can provide you with a low-cost solution to purchase ETFs. Check out my list of the best trading platforms in Canada to learn more.
TFSA vs. RRSP – Final Thoughts
The TFSA vs. RRSP debate might seem irrelevant once you understand that you can do so much better when you contribute to both. Whether you choose an RRSP or a TFSA, or even both, you will likely come out with the same amount of money because of the tax structure.
When you are saving and planning for your retirement, it pays to take a long-term approach with your investments and financial decisions. Hence, you should personalize your approach based on your short-, medium-, and long-term goals.
Understanding the features and benefits of both account types, their tax implications, and your long-term goals will help you make the best possible decision between the two or both.