Registered Retirement Savings Plan vs. Tax-Free Savings Account – What’s the Difference?

WEALTH MANAGEMENT

Both the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA) allow you to build savings in a tax-sheltered environment. So, what are the differences between the two – and when does it make sense to invest in one over the other?

The purpose of the RRSP, as its name states, is for long-term savings for your retirement. The TFSA is a more flexible vehicle to save for more immediate goals, such as buying a new car or a house, or creating an emergency fund. And it may also be used to save for retirement.

Who is eligible?

The RRSP has no minimum age, but you must have “earned income” in the prior year to create contribution room. Earned income includes income from employment, self-employment and certain other sources, and is reduced by some employment-related expenses, and business and rental losses. The RRSP matures in the calendar year in which you turn 71.

For the TFSA, you can begin contributing as of age 18, and there is no maximum age.

How much can you contribute?

With an RRSP, you can contribute up to 18% of your earned income in the preceding year, up to a maximum annual limit ($27,830 for 2021). Your contribution room is reduced when you have an employer-sponsored pension plan. The contribution for the year must be made by the 60th day of the following year – so, close to the end of March – and you can carry forward any unused contribution room indefinitely.

Keep in mind that if you overcontribute to your RRSP by more than $2,000, there is a penalty of 1% per month. You can deduct up to the greater of your actual contributions and your contribution limit for the year from your taxable income, reducing the amount of tax you pay on other sources of income.

TFSA contributions must be made by December 31 of the relevant year. Here are the annual contribution limits:

Similar to RRSPs, unused TFSA contribution room can be carried forward. For example, if you turned 18 in 2018 and have never contributed to a TFSA, your limit in 2021 is $23,500 ($5,500 + $6,000 + $6,000 + $6,000).

And as with an RRSP, you also face a 1% per month penalty if you go over your contribution limit.

What if you want to withdraw from the fund?

With an RRSP, you may be able to withdraw funds to buy your first home or finance a return to school without being liable for taxes right away.

• The Home Buyers Plan (HBP) allows you to withdraw up to $35,000 to help pay for your first home; you pay this money back into your RRSP through instalments over 15 years.
• Under the Lifelong Learning Plan (LLP), you can withdraw up to $10,000 in a calendar year, to a maximum total of $20,000, to finance full-time education or training for you, or for your spouse or common-law partner. These funds must be paid back through instalments over 10 years.

Any unpaid instalments for either the HBP or LLP are added to your taxable income for that year. Any other withdrawals from your RRSP are also included in your taxable income in the year that you receive them, and you cannot re-contribute that amount once you have withdrawn it.

Just as there was no tax deduction for TFSA contributions, you do not pay tax on TFSA withdrawals. You can recontribute the withdrawn funds to your TFSA in a subsequent year (just not the same year you withdrew it). The amount withdrawn gets added to your contribution room for future years.

How does having a spouse help you get the most out of these plans?

If you have a spouse or common-law partner, you can invest up to your contribution limit to a spousal RRSP. Generally, the amounts your spouse withdraws from these plans would be included in their taxable income, rather than in yours. Some restrictions apply.

If there is a significant difference between the incomes of two spouses, the spousal RRSP can minimize the total tax that the family pays in retirement by splitting income between one spouse in a higher tax bracket and the other in a lower tax bracket.

There are no spousal TFSAs. However, you can give money to your spouse for their own TFSA contribution and the income earned will not be subject to tax.

When does it make sense to invest in one vs. the other?

There are many factors that would affect whether investing in your RRSP rather than your TFSA may make sense, and these can be quite complex. Here are some general factors that you may consider helpful.

Your tax bracket

If you are in a higher tax bracket when you are making the contribution and expect to be in lower tax bracket when you will be withdrawing the funds, the RRSP can offer significant advantages. But if you are in a lower tax bracket when contributing, those benefits will not be as great – though you still benefit from deferring tax from the year you made the contribution to the year that you withdraw the funds.

Your timeline for withdrawal

The timeline for when you expect to need the funds is another important factor. When your RRSP matures in the year that you turn 71, you have two options for relief from being liable for taxes immediately: You may transfer the balance in the account to a Registered Retirement Income Fund (RRIF), or use it to purchase an eligible annuity.

RRIF plans require that you withdraw a minimum amount each year, based on your age. It’s also worth noting that any RRSP or RRIF withdrawals or annuity payments are added to your taxable income and may trigger a 15% clawback of the Old Age Security for income above a certain amount ($79,845 in 2021).

While the HBP and the LLP offer you some flexibility to access your RRSP funds without paying tax, the TFSA is much more flexible since you can withdraw funds on a tax-free basis and recontribute them in a future year.

Your investment type

Your choice of investment type may also affect your choice of RRSP vs. TFSA. For example, if your portfolio includes United States stocks, their Internal Revenue Service (IRS) recognizes the RRSP as a retirement savings account and does not withhold tax on the dividends you receive.

On the other hand, the IRS does not recognize the TFSA in the same way, so there will be 15% withholding tax charged on those dividends. There is no foreign tax credit to offset that 15%, as there would be for investments in a non-registered account.

The RRSP and the TFSA are both important savings vehicles for Canadians. Understanding the differences between the two can help you make the decision when to use either (or both!) to meet your savings goals.