RRSPs and TFSAs: Which one works best for me?
When it comes to saving money for retirement, both the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA) are popular choices. And for good reason. Each provides different advantages to help with your retirement and other savings goals.
The differences between RRSPs and TFSAs mostly come down to taxes:
- With an RRSP, your contributions reduce your taxable income resulting in lower income tax. You can only used earned income (typically, salary and rental income) to contribute to an RRSP and you can only contribute to your RRSP until you are aged 71, after which you must turn it into a RRIF or buy an annuity. If you withdraw money from your RRSP before retirement, you'll have to pay tax on the amount you take out.
- With a TFSA, you cannot deduct your contributions from your taxable income. However, when you withdraw your money from a TFSA, it's tax free. You can use any income (including inheritance, gifts, or other investments) to build up your TFSA. There are no upper age limits for your contributions and there are no penalties for early withdrawals.
- With both RRSPs and TFSAs, you pay no tax while you accumulate your savings.
- Both RRSPs and TFSAs have limits as to how much you can contribute each year.
Let's go into the different benefits of the tax timing for short-term and longer-term retirement savings:
- RRSPs are a great way to reduce your income taxes during your career when you expect to earn more than you will after retirement. When you deduct your RRSP contributions on your tax return that means you are deferring taxes on that income. You pay tax when you withdraw money from your RRSP during retirement--when you are most likely in a lower tax bracket compared to your career years. This saves you taxes over the long term, especially if you are very disciplined and re-invest your tax savings every year during your career! The RRSP contribution limit is the lesser of either 18 percent of your total earned income or the contribution threshold set annually by the CRA.
- When it comes to TFSAs, they work in the opposite way to an RRSP. When you contribute to your TFSA, you use money on which you have already paid taxes. TFSAs are not a tax-deferral strategy, which means you don't deduct your contributions on your income tax return. The benefit here is that you don't pay taxes when you withdraw from a TFSA, because you have already paid tax on the contributions. So, when you withdraw from your TFSA during retirement, that income is not reported on your tax return and will not move you to a higher tax bracket.
Which would work better for my retirement savings? This depends on several factors:
- If your average income tax rate is less than 20 percent, you are better saving in a TFSA. This is because you are likely to pay a higher tax rate during your retirement years due to investment earnings and additional income you'll receive from government pension plans.
- Once your average tax rate increases above 20 percent, the more likely your tax rate in retirement will be lower than when you were working. Now it makes sense to contribute to an RRSP and receive a tax refund.
- To further take advantage of tax savings during your career, you could also consider moving your TFSA to your RRSP, assuming you have enough RRSP contribution room.
- If you expect a significant retirement income from other sources than your RRSP, such as a good pension, or an investment portfolio, the additional taxable income generated by your RRSP withdrawals might mean that your Old Age Security benefit will be clawed back. In this case, building up a TFSA that doesn't generate a tax burden later in life and might be a better option.
- A combination of RRSPs and TFSAs is usually beneficial, and you should consult your financial advisor. Our Level 3 Calculators will enable you to easily determine which combination is most tax-effective.
What about other savings goals?
- When it comes to certain short-term savings goals, such as making a down payment on real estate, or paying for higher education, the TFSA has tax advantages whereby you are not taxed on your withdrawals.
- There are also tax advantages to withdrawing the deposit you make on your very first property purchase, from your RRSP.
- If you are the kind of person who has trouble with impulse purchases, maybe the tax penalties of withdrawing from an RRSP while you are still saving for retirement would make you think twice about withdrawing funds from your RRSP, helping you to achieve your savings goals.
For more personalized financial advice, please contact your financial advisor.