The debate about the Tax-Free Savings Account vs. Registered Retirement Savings Plan (i.e. TFSA vs. RRSP) has been ongoing in Canada for several years, and I foresee it remaining a hot topic in the future.
Although both are considered excellent savings and investing tools, sometimes, individuals would like to make a distinction between the two plans so they can choose one that best suits their financial realities.
In previous articles, I discussed the basics of the TFSA and summarized how the RRSP works. In order to put things into perspective in my take on the TFSA vs RRSP debate, let us first summarize the characteristics of both plans.
Tax-Free Savings Account (TFSA)
- You are eligible to contribute if you are at least 18 years of age and are a Canadian resident.
- Annual contribution limits are set by the Federal government and the contribution limit is indexed to inflation each year. For 2020, the limit remains at $6,000 (it was $6,000 in 2019).
- You can carry your contribution room forward from one year to another. If you have never contributed to a TFSA, your total contribution room in 2020 is $69,500.
- You can invest in almost anything through your TFSA including mutual funds, stocks, GICs, bonds, etc.
- Investment income earned is tax-free
- You can withdraw funds from your TFSA at any time without tax implications.
- Withdrawals from your TFSA can be contributed back the following calendar year or later and will increase your total contribution room.
Registered Retirement Savings Plan (RRSP)
- You can contribute up to 18% of your earned income less any pension adjustments, up to the specified maximum limit for the year. For 2020, the maximum limit is $27,230. It was $26,500 in 2019.
- You contribute pre-tax income and will get a tax refund when you file your tax return.
- Unused RRSP contribution room can be carried forward from one year to the next without penalty.
- There are different types of RRSP accounts including individual RRSP, group RRSP and spousal RRSPs.
- You will pay taxes on withdrawals from the RRSP except for purposes under the Home Buyer’s Plan and Lifelong Learning Plans.
TFSA vs RRSP: Similarities and Differences
TFSA or RRSP: The Dynamics
When it comes to making a choice between the TFSA or RRSP, many factors come into play. These include:
- What is your income tax bracket now?
- What will your income tax bracket be in retirement?
- What is the time horizon you have for retirement investing?
- How much do you need for retirement and how much funds are you investing?
- Do you have an employer contribution-matching plan?
When a TFSA May Be Preferable Over an RRSP
1. Earning a Low Income: If you are just entering the workforce and are earning a low-income (<40,000), a TFSA may be preferable. You can maximize your TFSA now while carrying your RRSP contribution room forward to future years when your marginal tax is higher and you will get more in tax refunds.
If earning a low income, or are close to retirement, and expect to qualify for the Guaranteed Income Supplement (GIS), the TFSA is preferable. This is because eligible GIS benefits decrease by $1 for every $2 in additional income above the maximum threshold.
If RRSP and other taxable income are high enough (more than $79,054 for 2020 – July 2020 to June 2021 payment period), there may also be a clawback of Old Age Security (OAS) pension. However, TFSA income does not count towards taxable income.
2. No Income: Funds contributed to a TFSA can come from any source. This means you can use the TFSA to start investing tax-free even if you are not working. RRSP contributions are tied to earned income.
3. High Tax Bracket in Retirement: Utilizing all your TFSA room is a good strategy if you expect to be in a high tax bracket in retirement. This will help to shield some of your retirement income from taxes. For those with significant pension plans, maximizing their TFSA may also reduce the amount of clawbacks of OAS by the government. For 2020, if your net income exceeds $126,058, your OAS benefit is reduced to zero.
4. Short Term Savings or Investing Goals: TFSA’s are an excellent saving tool for short to medium-term goals such as a car purchase, emergency funds, travel, etc. You can withdraw the money quickly without tax implications.
5. Investing after 71: Seniors can continue to contribute to a TFSA indefinitely, irrespective of their age. In contrast, RRSPs must be terminated and cashed out or converted to an RRIF.
6. RRSP Maxed Out: If you have already used up all your RRSP contribution room, the TFSA offers an additional opportunity to do more investing tax-free.
When an RRSP May Be Preferable Over a TFSA
1. Contribution Limit: An RRSP gives you more room to save for retirement than a TFSA. For example, in 2020, an RRSP gives you a maximum contribution of $27,230, while a TFSA provides only $6,000 contribution room. In order to meet your retirement goals, you may also need to maximize your RRSP.
2. Retirement Friendly: The RRSP was designed for retirement savings. It is difficult to access funds within your RRSP account without incurring severe tax implications. This may be a good thing as it may serve as an incentive to be disciplined with retirement savings. In contrast, funds within a TFSA can be easily accessed without penalty and squandered.
3. Group RRSPs: RRSPs are even more attractive if you have an employer who is matching your contributions. Irrespective of your tax bracket, if your employer is offering you “free money”, contributing your maximum to a group RRSP is a sound investment strategy.
4. Home Buyers’ and Lifelong Learning Plans: RRSPs offer other benefits to first-time homebuyers or those planning for further education. You can withdraw up to $35,000 from your RRSP to purchase a home or up to $20,000 to pay for full-time education. You have to pay back the amount in future years.
TFSA vs RRSP: Which is Better?
The TFSA and RRSP both offer excellent investment opportunities. While the RRSP remains a staple in retirement savings plans, the TFSA offers interesting savings strategies to high and low-income earners, seniors nearing retirement, and those without an income.
Depending on your circumstances, one or both plans would be suitable for your needs. It is important to carefully assess your current and future financial situation before deciding on the best approach to take.
The approach that works for me is to utilize both plans concurrently. I contribute as much as I can to my RRSP and when I get the tax refund, I put some or all of the refund into my TFSA.