What’s the Difference Between a TFSA vs. RRSP?

One of the most common financial questions that people have is what is the difference between a TFSA and an RRSP? Both of them are a type of savings account that you can use to hold funds for retirement, but they each have unique advantages and disadvantages.

In this article, we’ll go over what a TFSA is and how it works compared to an RRSP. We’ll talk about which one might be a better choice for you, depending on your financial circumstances and future goals.

So if you are someone who is looking to get started with saving for your retirement, or if you are thinking about changing the type of account that you currently have, then this article is for you!

What is a TFSA?

A TFSA stands for Tax-Free Savings Account. It was introduced by the Canadian government back in 2009 as another way to save for your future. The idea with a TFSA is that you can invest money in it, after tax money. And the best part is that when you do this, there are no taxes on any of your investment earnings, neither as your investment grows nor when you withdraw. Never!

Not only that, but a TFSA gives you the flexibility to use it for anything: down payment, a trip, a car, anything. This tax sheltered account can house your investments with a variety of investing options such as mutual funds, bonds, securities, etc.

Current deposit limit for 2022 is $6,000 (Canadian dollars). This limit will rise in future. This is a very powerful tool that Mr. Flaherty set up.

If you’ve never contributed, you can deposit $81,500 today. Remember, you are depositing after tax money, ex. you sold your home or trailer and you have ‘cash in pocket’. Better put that cash in an account where you pay no tax than a ‘savings’ account where growth is taxable.

What is a RRSP?

RRSP stands for Registered Retirement Savings Plan. An RRSP is a savings plan, registered with the Canadian federal government that you can contribute to for your retirement. Funds that you contribute to a RRSP are considered “tax-advantaged” because they’re exempt from being taxed in the year you make the contribution and all subsequent years. You pay tax on the funds only when you start making withdrawals in the future (at retirement). In other words, you write off the income making this non taxable. To illustrate, let’s say you earned $75k last year. If you put $10k into your RRSP, you’d only pay income tax for last year on $65k. i.e. you save paying the tax on the $10k.

The RRSP was introduced back in 1957 in Canada as a part of Canada’s Income Tax Act. Like the TFSA, the RRSP also offers different types of investment vehicles such as mutual funds, bonds and GICs, etc.

The Canada Revenue Agency calculates your RRSP deduction limit as 18% of the earned income amount that you reported on your previous year’s tax return, to a maximum of $29,210 (if you earned $162,278). Then, deduct any deposits to your pension plan.

Advantages and disadvantages of TFSA

Before you choose to invest in a TFSA, it is a good idea to understand its advantages and disadvantages.

Advantages

1. No tax on your investment income: As we mentioned above, when you put money into a TFSA, there are no taxes whatsoever on any of your investment earnings. So if you manage to make a good return on your money, then all of those earnings will be yours.
2. You can take out the money whenever you want: Another great thing about TFSA is that, unlike an RRSP, there are no penalties for taking the money out early! So if needed, you can withdraw some or all of the money right away. Then next calender year, you can re-deposit without penalty.
3. You have full flexibility to choose your type of investments: TFSA allows you to choose any investment that you want for your investment purposes: stocks, bonds, options, GICs, etc.

Disadvantages

1. Limited contribution room: With a TFSA, the government gives you a certain amount of room to save every year. The limit has been set to $6,000 per year, set to rise in future.
2. No protection from creditors: When you deposit money into a TFSA, it is not protected from your creditors. So if you go through a difficult time & declaring bankruptcy or are sued, the funds in your TSFA are treated like any other personal savings account.
3. Day trading is prohibited: Unlike a regular account which allows you to day trade, this is not allowed with a TFSA. So if you plan on using it as a trading account, then you will have to open a regular non registered account instead.
4. Contributions are limited: There is a limit on the amount that you can contribute to both your RRSP & TFSA per above.

Advantages and disadvantages of RRSP

The main reason to invest in an RRSP is to save for retirement. It offers a great tax deduction, and your money will grow tax-free, but it’s fully taxable when you withdraw.

Advantages of a RRSP:

1. Contributions are tax-deductible: When you put money into your RRSP, the government allows you to deduct that amount from your taxable income. So if you make $50,000 a year and put $5,000 in it, then your taxable income will be reduced from $50,000 down to $45,000.
2. Tax-deferred growth: By putting your money in an RRSP account, there are tax advantages on the growth of your money. Returns are exempt from any capital gains tax, dividend tax, or income tax. Gains are “sheltered”.
3. Good for retirement planning: One big advantage of RRSP is that it allows you to plan for your retirement. In many cases, people end up making a lot less in the years when they retire. If you put money into an RRSP early on, you will have funds to live off once you retire. Deposit at a high tax rate and withdraw when you are in a lower tax bracket.
4. Protected from creditors: Funds in your RRSP are protected and covered under Canada’s Bankruptcy and Insolvency Act if you declare bankruptcy. So, an RRSP provides asset protection from creditors and legal proceedings.
5. You can borrow money from your RRSP for buying a home or paying for education: Another great benefit of having an RRSP is that you can borrow money from it for buying a house or paying for your children’s education through the Home Buyers’ Plan (HBP) and the Lifelong Learning Plan (LLP). These plans allow Canadians to pull funds out of their RRSPs  interest and tax-free in order to buy a home or get educated. Keep in mind, it does need to be paid back (over 15 years for the HBP and 10 years for the LLP).

Disadvantages of a RRSP:

1. You have to pay a penalty for withdrawing: Unlike a TFSA, if you withdraw any money from a RRSP at any time, the government charges you a “witholding tax” for withdrawing. This tax amount depends on how much you take out and where you live, but in general will be between 10%-30% of the amount withdrawn. All RRSP withdrawals are added to your income. If you are still earning income, you may find yourself in a higher tax bracket. Another consideration, you lose your contribution room. You don’t gain that contribution room back. Compare to TFSA, you ‘re gain’ that contribution room the following January 1st.
2. Contribution limits depend on your income: RRSPs are only beneficial if you make enough money. The more you earn, the higher your contribution limit is. Your goal is to deposit to the RRSP when your income is high.
3. You have to close your account by the age of 71: Another downside of RRSP is that you have to close your account by the age of 71. It must be used for retirement purposes. After that, you have to change your savings account into a TFSA or any other investment account.
4. Low liquidity: Your RRSP is meant to be a long-term savings vehicle that you don’t touch until your retirement, this can be a disadvantage if you need to take the money out sooner. Yes, you can withdraw, but it’s all taxable.

Which one should you choose?

It depends on your unique situation. Both accounts come with their unique benefits, so you have to decide what is more advantageous for your specific retirement and savings goals. If you want to invest money for short-term savings, then go with a TFSA account. On the other hand, if you want to save up for retirement or pay for your kid’s college education, a RRSP is a great choice meant for long-term retirement planning.

The best part is, you can open both of the accounts without any issue! You can contribute to both your TFSA and RRSP every year. By doing this, you can take full advantage of both accounts! Best to deposit in January of any year to take full advantage of the tax sheltering.

A good rule of thumb in life: contribute 10% of your income to a savings plan. Always. Your retirement will be successful.

Conclusion

In this article, we have talked about the difference between Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP). We talked about their advantages and disadvantages. You can choose either of these depending on your financial situation or you can choose to use both. We hope this article was helpful, thanks for reading!

At Pension Solutions Canada, we specialize in assisting people in preparing for retirement. Allow us to evaluate and review your retirement income sources and assist you with retirement planning. Call us at 1-888-554-6661, or click here to book a virtual Zoom meeting.