When saving your hard-earned cash for a big purchase, emergency, or your future, you have two options to minimize your taxes. The federal government offers two types of accounts designed to help you get the most out of your savings: a Tax-Free Savings Account (TFSA) and a Registered Retirement Savings Plan (RRSP). Both accounts are excellent financial tools that allow you to save money and reduce your taxes, but is a TFSA or RRSP better for your financial goals?
TFSA vs. RRSP: What’s the difference?
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Depending on your current savings goals, one account might be more suitable than the other. We’re going to look into the difference between RRSP and TFSA to help you decide which version you should use and when.
TFSA vs. RRSP: Overview
What is a TFSA?
The federal government introduced the TFSA in 2009 as a straightforward and tax-free way to help Canadians save for their future. You can open a TFSA at any financial institution and use it to hold cash, GICs, stocks, bonds, ETFs, and more. When you contribute money to your TFSA, any growth within that account is exempt from taxes. So if you use your TFSA to invest for your future, it can become a powerful tool for tax-free growth.
Of course, there are some limitations to how much you can contribute to a TFSA, known as contribution room. As a Canadian, you are entitled to $6,000 worth of contribution room in your TFSA yearly starting in 2009. If you have never used a TFSA before and were over 18 in 2009, your contribution room is $75,500.
If you’re not sure how much contribution room you have in your TFSA, you can check by logging into the Canada Revenue Agency’s My Account feature.
What is an RRSP?
An RRSP is another type of registered account that works a little differently. You can still open an RRSP at any financial institution and use it to hold cash, stocks, bonds, ETFs, and more, but the government treats your contributions to an RRSP in a slightly different way.
When you contribute to an RRSP, you’ll deduct that amount from your current or future taxes, reducing your taxable income for that year. However, when you withdraw the money, you’ll pay taxes on it.
Saving money in an RRSP is helpful for those who will have a lower income when they plan to withdraw the funds, such as in retirement, because it reduces your total tax payable in your lifetime.
There are contribution limits to your RRSP, set at 18% of your gross income per year and cumulating year after year
TFSA vs. RRSP: How They Work
We briefly described how TFSAs and RRSPs work above, but we’ll go into more detail below.
TFSA: How It Works
First, you’ll open a TFSA at a financial institution and begin making contributions. Then, you can keep that money in cash, buy GICs, or invest it, all within the TFSA. Any interest that you earn on cash or investments held within a TFSA is not taxable, and you can make withdrawals at any time with no penalties.
You’ll have a maximum limit to the amount you can contribute to your TFSA. Currently, the maximum contribution room is $75,500, and every calendar year, you’ll get another $6,000 in contribution room. If you withdraw money from your TFSA, you’ll get that contribution room back in the following calendar year.
For clarity, let’s use an example.
You currently have $30,000 in TFSA contribution room. If you open a TFSA and deposit $10,000, your remaining contribution room is reduced to $20,000. If you withdraw $5,000 of that money this year, your contribution room continues to be $20,000 for the rest of the calendar year. In the new year, you’ll get that $5,000 in contribution room back, plus an additional $6,000 that you are entitled to every new calendar year, for a total contribution room of $5,000 + $20,000 + $6,000 = $31,000.
Money deposited into your TFSA grows tax-free, and the ease with which it can be withdrawn makes it a popular choice for saving significant amounts of cash. We think a TFSA is also an excellent account to hold investments in because all interest earned in a TFSA is tax-free.
RRSP: How It Works
RRSPs work similarly to a TFSA but with a few key differences. You can open an RRSP at any financial institution and make contributions. You can hold that money as cash, you can buy GICs, or you can choose to invest within your RRSP.
When you deposit money into an RRSP, you can deduct that amount from your taxes, either this year or in subsequent years. These deductions will lower your taxable income and boost your income tax refunds. There is a catch, however. Any withdrawals from an RRSP are treated as income, and you’ll have to pay taxes on it. For this reason, most Canadians opt to use an RRSP to save for retirement because they expect to have a lower income in retirement and pay less tax on money withdrawn from their RRSP.
Two programs let you withdraw money from your RRSP tax-free. The Home Buyer’s Plan lets first-time homebuyers withdraw up to $35,000 tax-free, and the Lifelong Learning Plan allows those returning to school to withdraw up to $20,000.
Just like the TFSA, there are limits to how much you can contribute to your RRSP, known as your contribution room. Every year, you’ll earn 18% of your income in contribution room. Contribution room is carried forward year after year, minus any contributions you make.
For example, if you have $9,500 in contribution room and deposit $6,000 in your RRSP, your contribution room is reduced to $3,500. In the following year, you’ll earn more contribution room equal to 18% of your income, plus the existing contribution room.
RRSP vs. TFSA: Similarities and Differences
RRSPs and TFSAs have many similarities, but the differences may help you determine which one is right for you.
TFSA vs. RRSP: The Similarities
Despite their names, neither the TFSA nor the RRSP have to be used purely as savings accounts. Instead, think of them as baskets in which you can put a variety of financial products, including cash, GICs, stocks, bonds, ETFs, and more. In addition, since you can use both the TFSA and RRSP to hold investments, both of these accounts can be powerful investing tools.
Both accounts have contribution maximums that you’ll need to respect. With a TFSA, you’ll receive $6,000 in contribution room per year, up to a current maximum of $75,500. With an RRSP, your contribution room equals 18% of your gross income. With both accounts, your contribution room is cumulative, and over-contribution will result in penalties.
TFSA vs. RRSP: The Differences
The most significant difference between a TFSA and an RRSP is how your contributions are taxed. The differences in taxation will impact how much tax you pay overall and whether it makes more sense to contribute to a TFSA or an RRSP.
When you contribute after-tax dollars to a TFSA, your money goes into the account, where it will grow tax-free. Then, you can withdraw it at any point with no penalties. This direct deposit and withdrawal scheme makes TFSAs a top choice for saving significant sums of money, such as emergency funds and house down payments. That said, the tax-free growth in a TFSA also makes it an excellent choice for long-term investing.
RRSPs are a bit more complicated. When you contribute to an RRSP, you’ll generate a tax deduction that you can use to reduce your taxable income. This deduction makes RRSP contributions essentially tax-free at the time of contribution. That said, you will pay tax on all withdrawals. Taxable withdrawals make an RRSP an ideal savings vehicle for retirement and allow you to defer paying tax on your money until retirement.
TFSA Pros and Cons
Pros
Deposits can be withdrawn at any time
Growth inside a TFSA is tax-free
Can hold cash, GICs, stocks, bonds, ETFs, and more
Current lifetime contribution limit of $75,500
Withdrawals are tax-free
Contribution room is cumulative and withdrawal contribution room is returned the following calendar year
Cons
No tax deduction for contributions
Overcontribution can result in penalties
RRSP Pros and Cons
Pros
Can hold cash, GICs, stocks, bonds, ETFs, and more
Tax-sheltered growth
Contribution room is 18% of gross income per year, cumulative
Contributions are tax-deductible
Can carry forward unclaimed tax deductions in future years
Exceptions to withdrawals as taxable income include $35,000 for first-time homebuyers and $20,000 for continuing education
Cons
Withdrawals are taxable as income
Mandatory withdrawals start when you turn 71
Overcontribution can result in penalties
Bottom Line
Based on our evaluation, we think that both the TFSA and RRSP are good options for tax-sheltered growth of your money, but each type of account excels in certain circumstances. For example, the TFSA’s straightforward contribution rules, along with its tax-free withdrawals, make it a flexible option for saving large sums of money or even for retirement. That said, the TFSA may be a little too flexible, and it may be difficult for some Canadians to leave their investments alone in this account.
For these people, an RRSP could be an excellent choice to save for retirement. The RRSP’s high contribution limits and tax deduction–generating contributions give Canadians an immediate bonus for contributing. In addition, the taxable withdrawals represent enough of a deterrent that we think this tax-sheltered account is a good choice for anyone who might be tempted to raid their retirement funds.
Rachel Cribby
Frequently Asked Questions
Yes, the TFSA and RRSP are both registered accounts, which means that when you open a TFSA or an RRSP at a Canadian financial institution, it will have tax-sheltered or tax-deferred status. In the TFSA’s case, interest earned in this account is tax-free. In the RRSP’s case, you’ll only pay tax when you withdraw money.
Interest earned in these accounts is not taxed in the same way as interest earned in non-registered accounts. Other examples of registered accounts in Canada include RESPs and RRIFs.
Both TFSAs and RRSPs limit how much you can contribute, and overcontribution will result in penalties. Your TFSA has an annual contribution limit of $6,000 per year, and this limit is cumulative. That means if you were over 18 when the TFSA was introduced in 2009, your total contribution limit is $75,500. Your RRSP’s contribution limit is 18% of your annual income and is also cumulative.
If you aren’t sure how much contribution room you have, you can check by logging into the Canada Revenue Agency’s My Account portal.
IYou can save for a house down payment in both an RRSP and a TFSA. If you save in a TFSA, you can deposit money up to your contribution limit and it will grow tax-free. In addition, you can withdraw money from your TFSA at any time with no penalties.
If you are a first-time homebuyer, your RRSP can also be used to save for a home down payment, and your contributions will generate tax deductions, which you can use to lower your taxable income. First-time homebuyers can withdraw up to $35,000 from their RRSP without having to pay tax on that amount, but you’ll need to pay that withdrawal back over 15 years.
