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The difference between RRSPs and TFSAs
Contributed article by Beverly Wilks, tech marketing executive, financial literacy champion and blogger at Bacon & Heels.
Saving for your old age or for general saving is a smart move. Both RRSP and TFSAs are great options for Canadians to save as well as take advantage of tax advantages of both these investment vehicles.
Let’s dive into these two Canadian investment vehicles and you can determine which one, or both, is good for you.
RRSPS, TFSAS & TAXES
RRSPs and TFSAs both have tax advantages, but some of these advantages are greater than others, depending on the financial situation of the individual.
The main difference between an RRSP and a TFSA is the timing of taxes:
An RRSP lets you defer taxes – an advantage if your marginal tax rate is lower in retirement.
With a TFSA, you’ve already paid tax on the money you contribute – an advantage if your marginal tax rate is higher when you withdraw the money.
A Tax-Free Savings Account (TFSA) can be used to save for any goal. Since you put after-tax dollars into a TFSA, these investments grow tax-free and you won’t pay any tax when you withdraw the money. You can hold a wide variety of investments within a TFSA, such as: cash, GICs, bonds, stocks, mutual funds and ETFs.
An RRSP is a way to defer taxes and a good way to save for retirement. Many investment vehicles can be held in this account such as GICs, bonds, stocks, mutual funds and ETFs.
TOP 8 DIFFERENCES BETWEEN RRSP’s AND TFSA’S
An RRSP is intended for retirement savings. A TFSA can be used for any type of savings goal.
RRSP contributions are tax deductible. TFSA contributions are not. With an RRSP, you deduct your contribution from the income you report on your tax return. With a TFSA, you can’t deduct your contribution on your tax return.
Gains in a TFSA are tax free. Gains in a RRSP are tax-deferred.
You pay tax on your RRSP withdrawals because you made the contributions with pre-tax dollars. TFSA withdrawals are tax free because you made the contributions with after-tax dollars.
The last day you can make contributions to your RRSP is December 31 of the year you turn 71, after which the RRSP must be closed. At that time, you can either convert your RRSP to a Registered Retirement Income Fund (RRIF) or buy an annuity. With a TFSA, you don’t have to stop contributing or close the account, you can continue to contribute at any age. Although you need to be 18 years old to open a TFSA account.
You need earned income to contribute to an RRSP, but you do not need earned income to contribute to a TFSA.
The penalty for over contributing to a TFSA is 1% per month, the RRSP penalty if you over contribute is 1% per month, but only if the amount is over $2,000.
With both plans, you can name your spouse as a beneficiary. The money will roll over to them upon your death. But with an RRSP, after your spouse dies, taxes will be due on any money left in the account. So if your children inherit the money, they will receive what is left after the tax is paid. With a TFSA, only the increase in the value of the TFSA since the date of death is taxed in the year the children receive it. If the amount they receive is not greater than the value of the TFSA at death, no tax is paid.
WITHDRAWING FROM AN RRSP & TFSA
An RRSP is a great retirement savings and tax deduction vehicle, but early withdrawals from your RRSP have hidden costs that can hinder your retirement plans, namely loss of tax-sheltered compounding.
RRSP withdrawals are taxable - If you withdraw up to $5,000, the withholding tax rate is 10%; if you withdraw between $5,001 and $15,000, the withholding tax rate is 20%; and if you withdraw more than $15,000, the withholding tax rate rises to 30%. Note that these tax rates apply to everywhere in Canada except Quebec, where provincial tax rates apply on top of the federal withholding tax.
Early withdrawal = permanent loss on contribution room - When funds are withdrawn from an RRSP (before the age of 71), you permanently lose the contribution room you originally used to make your deposit. While you can continue making your maximum contribution to your RRSP in the future, you can’t re-contribute the amount you withdrew. This reduces the potential value of your RRSP at retirement.
For example, if a 40 year old withdraws $6,000 from their RRSP today, after 25 years (assuming you earn an annual 7% return), the RRSP account will have over $32,000 LESS in the account, than if the withdrawal hadn’t been made.
When withdrawing from a TFSA these accounts don’t increase your taxable income, but you will give up the potential investment earnings.
So there you have it, a quick way to compare and contrast the differences between a RRSP and a TFSA. Let me know what you are planning for your RRSP and TFSA.
To learn more about saving, taxes and investing, visit www.BaconHeels.com and follow on Instagram at @bacon_and_heels
To learn more about Beverly, we did our "Power 5" interview with her in September 2021 - you can read the full blog post HERE.
Thank you for your contribution Beverly!
Contributed article by Beverly Wilks, tech marketing executive, financial literacy champion and blogger at Bacon & Heels.