Making the right choice between a Tax-Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP) could save you a LOT of money!
An RRSP is the right path for you if:
- Your annual income exceeds $50,000, an RRSP is likely more beneficial than a TFSA. Contributions to an RRSP reduce your taxable income, resulting in a significant tax refund. The strategy is to contribute while you’re in a high tax bracket and withdraw in retirement when you’re in a lower bracket, thereby paying less tax on your withdrawals.
For example, If Chris earns $90,000 annually and contributes $5,000 to their RRSP, they could save up to 40% in taxes on that $5K, effectively boosting their refund by $2,000. When they withdraw this money in retirement, their lower tax rate (e.g., 33%) means Chris will keep more of their savings.
- Your investment strategy includes holding U.S. stocks in your portfolio, then the RRSP is the best choice for you. Unlike a TFSA, RRSPs are recognized by the U.S. government as retirement accounts and are generally exempt from the 15% withholding tax that the US usually applies to dividends paid to non-US residents. This exemption does not apply to the TFSA.
- Your savings goals are for your retirement. or a major life event? Since your contributions to an RRSP are tax-deductible, you are reducing your taxable income for the year to contribute, resulting in significant tax refunds (especially if you’re in a higher tax bracket). Of course, you’re going to reinvest that tax refund right back into your RRSP aren’t you! The money you have invested in your RRSP is now growing tax-deferred, meaning any interest, dividends, or capital gains earned within that account are not taxed until you withdraw the money, in your retirement. Because you’re not paying taxes annually on the growth, your investments are compounding efficiently, leading to a nice pile of money in your retirement fund.
- You or your spouse earns significantly more income than the other. The higher earner can contribute to the lower income earners spousal RRSP. The contributing spouse gets the immediate benefit of a tax deduction for the contribution which reduces their taxable income for that year. When the lower-earning spouse starts withdrawing from the spousal RRSP in retirement, the withdrawals are taxed at their (usually lower) tax rate. Effectively splitting the income between the two spouses and reducing the overall household tax burden.
A TFSA is the right path for you if:
- Your income is lower than $50,000 annually. An RRSP’s tax deduction may not provide significant benefits because your current tax rate is already low. Also, withdrawing from the RRSP in retirement might see you paying taxes at a higher rate, especially if your retirement income increases. A TFSA, however, offers more flexibility since your contributions aren’t tax-deductible, but your investments grow tax-free, and withdrawals are also tax-free. For example, if Bart earns $40,000 a year, contributing to a TFSA allows him to save and invest without worrying about future taxes, making it a better option for his situation.
- You’re planning a big purchase, like a home —you don’t get much bigger than that here in Metro Vancouver where I live. A TFSA is an ideal savings tool because it offers flexibility and freedom from restrictions. You can contribute to your TFSA, let your investments grow tax-free, and withdraw funds whenever you need them without incurring tax penalties. Plus, you can re-contribute the withdrawn amount in the following year, keeping your savings plan on track. For example, if Joy saves $90,000 in her TFSA for a down payment, she can withdraw the full amount tax-free when the time comes and then start to re-contribute that $90,000 the next year to continue building her savings.
- You’re thinking about government benefits in retirement. If, like many fellow Canadians, you anticipate relying on government benefits like Old Age Security (OAS) or the Guaranteed Income Supplement (GIS) during retirement, a TFSA is an excellent choice for your savings. Unlike RRSP withdrawals, which are considered taxable income and can reduce your OAS or GIS benefits, TFSA withdrawals are tax-free and do not affect your eligibility for these benefits. For example, if Jen, a retiree, withdraws $10,000 from her RRSP, it could push her income above the threshold and reduce her GIS payments. However, if she had saved in a TFSA instead, she could withdraw the same $10,000 without impacting her government benefits.
You’re a student or if you have a changeable income. A TFSA is a more straightforward and effective savings option because it isn’t tied to your income or your tax bracket. Unlike an RRSP, which provides tax deductions that are more beneficial for higher earners, a TFSA allows you to save and invest regardless of how much you make. Your investments grow tax-free, and you can withdraw funds without any tax implications. For instance, if Amal, a student with a part-time job, saves $2,000 in a TFSA, his money grows tax-free, and he can access it anytime without worrying about tax deductions or penalties, making it an ideal choice for his situation.
Should you only use one?
No! Here’s the thing, balancing contributions to both an RRSP and a TFSA can maximize your retirement savings and tax efficiency. For high-income earners, prioritizing RRSP contributions makes sense because the immediate tax deduction can reduce your taxable income significantly. By then investing the tax refund into a TFSA, you create a tax-efficient growth strategy where your savings can grow tax-free.
On the other hand, if you’re starting with a lower income, beginning with a TFSA allows your investments to grow tax-free and gives you the flexibility to withdraw funds without penalties. As your income rises, shifting some of your TFSA savings into an RRSP can provide a valuable tax deduction, helping you optimize your financial strategy.
Always keep an eye on your CRA account online for both your TFSA and RRSP contribution room annually. If you’ve maximized your RRSP contributions and still have funds to invest, consider topping up your TFSA to benefit from tax-free growth and flexible withdrawals.
TLDR? Check out the infographic below or the downloadable format in RESOURCES.
