Which is better, RRSP or TFSA?
When we start saving, we all want to make sure we are doing everything right - it’s perfectly natural to want to make sure you get the best bang for your (in this case literal) buck. For years, the only way to let your savings grow tax sheltered for retirement outside of employer pensions, was the Registered Retirement Savings Plan (RRSP). This has been the go-to tool for retirement planning for ages. However, in 2009 a new type of tax-sheltered account was introduced, the Tax Free Savings Account (TFSA) and ever since the question has been - which is better? Where should I be saving my money?
Let’s be clear, if there was one definitive answer, it would have been found a long time ago and everyone would be doing that. Like most things in the financial world, the answer is - it depends. While both accounts have the advantage of tax sheltering the growth of your investments while registered, how much you can contribute and how tax does play a factor can mean RRSPs are better for some, TFSAs for others, or even utilizing a combination of both accounts.
To understand which account makes sense for you - let’s do a brief overview of each account type.
Registered Retirement Savings Plan (RRSP)
The OG individual savings account. This plan allows you to contribute up to 18% of your prior year’s earned income (up to an annual maximum, for 2022 the maximum is $29,210) to grow tax sheltered in the plan, with unused contribution room carrying forward to future years. As an added bonus, contributions made are used to deduct your taxable income. This is a win-win right? Well, as you may have guessed, the government does want to extract its pound of flesh somewhere, and in this case it’s when you withdraw from the plan. All withdrawals from RRSPs are taxable as income in the year they are taken.
In addition, RRSPs must be converted to a Registered Retirement Income Fund (RRIF) no later than the year in which you turn 71. Why does this matter? RRIF’s have a minimum amount that must be withdrawn each year, meaning a percentage of your portfolio is guaranteed to be coming out as taxable income in each year. This income is included when considering means tested benefits, such as OAS.
If you are in high earning years today, and plan to retire early or have a modest retirement (and therefore your marginal tax rate is higher now than it will be in retirement) this is great for you, as you get to reduce your taxable income at a higher level, and pay tax later at a lower level. If you are in a relatively low tax bracket now, or have a particularly long time horizon, the amount coming out later may be taxed at a higher level than the deduction you are getting today - which is less than ideal.
Other things of note with RRSPs is that unless you fit into a specific program (such as first time home buyers or lifelong learning) withholding tax is applied at source to early withdrawals (so if you decide you need $10,000 and to pull it from your RRSP’s you will only receive $7,000). Depending on your tax rate, you may get some of the $3,000 back at tax time or you may owe additional funds, but it is important to be aware of what will actually hit your bank account relative to what you withdraw. In addition, that contribution room is lost - along with the compounding of returns tax sheltered that would have come along with it.
For these reasons, if you are in a higher tax bracket and want to earmark these funds for retirement, an RRSP may be the best account for you.
Tax Free Savings Account (TFSA)
And now we have the shiny new account! I have talked about TFSAs at length here. Contributions are the same regardless of your income level, but only begin once you turn 18. Contribution room is carried forward if not used in current years. Like an RRSP, the growth of your investments in a TFSA is tax sheltered.
The first big difference between the two accounts is that you get no deduction when you contribute to your TFSA - you earn your income, pay tax on it, and take your after tax balance to make your contributions - booooo right? Not necessarily, as in this case funds withdrawn from the TFSA are not subject to any further tax, nor are they used as a basis for means testing. So if you are in a lower tax bracket today, you will pay your lower taxes now and let your balance grow through time, before withdrawing tax free in the future.
In addition, contribution room is restored to your account in the calendar year after you’ve withdrawn it - so if you needed $3,000 for an emergency vet bill in 2021, and used your TFSA to pay for it, in 2022 you would have gotten your $6,000 in annual contribution room plus the $3,000 from last year’s withdrawal for a total of $9,000 in total room this year.
Due to the upfront nature of taxes and flexibility with contributions, if you are in a lower tax bracket today or think you may need the funds in the future a TFSA may be the best account for you.
Are those my only options?
No! In 2023, the Government introduced a “First Time Home Buyers Savings Account” (FHSA for short as that really is a mouthful) that combines elements of both RRSP and TFSA accounts to provide the best of both worlds, as long as you qualify as a first-time home buyer.
In addition, if you have kids there is another option available - a Registered Education Savings Plan (RESP).
An RESP is an account that is funded with after tax dollars (so no deduction on the contributions), but in addition to growing tax sheltered inside the plan, also has the benefit of being given some government dollars (Canada Education Savings Grants and Canada Learning Bonds).
You may be familiar with the basic CESG - this is the 20% match up to $2,500 in contributions made in a year (so $500 per year in government grants, to a maximum of $7,200 per child). However, lesser known is that fact that if you miss a year it can be made up in the future, and that lower income households may get additional match on the first $500 contributed in a year.
In addition, lower income families may receive what’s known as the Canada Learning Bond, which does not have a contribution requirement, for up to $2,000 per child.
Once your child attends post secondary (which includes certain apprenticeships and trade programs in addition to conventional universities and colleges) they withdraw the funds from the account. Since the contributions were made with after tax dollars, those are withdrawn tax free, but the growth and government grants are withdrawn as an Educational Assistance Payment, and taxable in the hands of the child (generally at a lower income tax bracket than the parents). If the child doesn’t fully use the balance in the account, the interest earned may be transferred to an RRSP for one of the plan’s subscribers provided they have contribution room (government grants would however be returned).
I will touch on RESP plans in more detail in a future post - including some things to look for in setting up your RESP both in providers and plan structure.
Anything else?
If you are lucky enough to have maxed out your contributions in all these areas, there may be some more complex tax and planning strategies that are applicable to you - these should always be discussed with your financial planner and your accountant to determine if they are right for you. I will touch on some these at a high level in a future post.
You can also keep building up your portfolio in a non-registered account which does not have any tax sheltered growth but will still give you access to the equity and fixed income markets. There are lots of factors to consider when determining which account is the best for you - some of which are discussed here.
What now?
Once you determined which is the best account for you all you need to do is make a plan to save and stick to it - most institutions will let you set up an ongoing savings schedule so that you can contribute without thinking about it. I often work with clients to look at their budget available and work with them to determine the right savings amount, if you want to discuss what works for you please reach out here.
If you want to make a contribution to your RRSP to deduct against your 2021 income, you have until March 1st to make the contribution, so talk to your financial planner today about if that makes sense for you.
Elyce Harris is a CFA Charterholder working with Cornerstone Investment Counsel, a registered ICPM in Alberta, Canada. She is also a licensed insurance broker in Alberta, Ontario, and PEI. While every effort is made to ensure the accuracy of statements, errors may occur. If a specific stat or carrier policy is cited, a source will be provided, however this is not done for generalizations.