Disclaimer: I am not a financial or tax advisor. You are trading at your own risk and should consult a financial advisor and/or tax advisor for any investment decisions. Do your own due diligence when considering investing, and this information is for education/informational purposes only. The article “Understand The Staggering Differences Between TFSAs And RRSPs Now” serves as educational content, not investing or tax advice.
Ah yes, the TFSA and RRSP. These two investment accounts are the most popular across Canada, with good reason, of course. Both registered accounts provide their benefits, but do you know what those benefits are?
Do you know the difference between a TFSA and an RRSP?
You’re right in that you can hold stocks, bonds, ETFs, or interest in them, but several unique characteristics separate the two accounts from each other. It’s because of these characteristics that people hold one over the other and not both.
So today, I’ll discuss what each account is, provide some examples, talk about the benefits to each account, all so you can learn the difference between them and brag it to your friends.
what is The rRSP and tFSA:
To understand the differences and benefits of each account, let’s briefly review what each account is.
RRSPs are registered retirement savings plans and each are registered with the Canadian Government. This means that the Government can track your contributions and withdrawals to ensure you get the correct amount of tax deductions and tax withholdings on your income tax returns.
The RRSP is designed for you to contribute your before-tax dollars to this account. Yes, your before-tax dollars. It entitles you to receive tax deductions on your income tax returns. So, for example, if you were to contribute $1,000 into your RRSP account, your taxable income will be $1,000 less. We will discuss this more down below.
There is no age limit to contributing to this account. So you can start if you are 16; for example, the only requirement to contribute to the account is to have a SIN (social identification number) and a bank account. However, since most Canadians have these, there is a minimal hassle to open an RRSP.
However, there is only a specific amount you are entitled to contribute yearly. The annual contribution limit is calculated as the following for the current year:
The lessor of:
18% of your earned income
Annual contribution limit of $27,830
We’ll look at an example in the following categories below.
TFSAs, better known as a Tax Free Savings Accounts, is another account registered with the Canadian Government for the same reasons as the RRSP. But the most significant difference between an RRSP and this account is that with the TFSA, you contribute your after-tax dollars.
So the contributions you’ve made have already been taxed. So if we look at the $1,000 from the example above, well, you’ve been taxed on it already, so your taxable income is technically unaffected. The ultimate benefit is that any withdrawals made in this account are tax-free.
This means that any income earned within this account is tax-free. Dividends, capital gains, interest are all tax-free. Yes, let me repeat myself for the 4th time. It’s tax-free. If that isn’t beautiful, what is in this world?
Yet, while I wish we could all reap the benefits from this account, there are certain restrictions on the amount you can contribute. Every year, the Government announces the annual contribution limit that investors can contribute for the given year. For 2021, it was $6,000, as it was in 2020 and 2019.
So while $6,000 isn’t a large amount, considering the much more considerable amount you may be eligible to contribute to an RRSP, however, not everyone has $6,000 to contribute to their investments in a given year. It’s a very suitable amount to contribute to the investment account itself.
Now that we have a basic understanding of the TFSA and RRSP, now let me highlight some of the critical differences and even similarities of both of these investment accounts. When reading this, you’ll even understand about the benefits of the RRSP vs TFSA:
Differences between a TFSA and RRSP
While I recently discussed the contribution limits, I want to discuss them a little further. Each contribution limit is calculated very differently. Once the Canadian Government prescribes it, the other is an actual calculation.
Let’s finally look at an example of how the RRSP contribution calculation is calculated:
The annual contribution limit is solely based on the earned income you earn. Earned income is based on employment income, business income, royalties, net rental income, and other income. For this example, I wanted to keep it simple with the three different payments.
For this case, since the 18% of the $61,000 is much lower than the annual limit, the percentage is used instead of the other.
In these cases, individuals will find that they can contribute more to an RRSP versus a TFSA, and as I’m basing the above example in 2021, the TFSA limit is $6,000. Every year, people will find that there may be a difference between these two amounts.
Another big decision for people to choose between the TFSA and RRSP is based on the withdrawals they will make. It’s the most significant decision for many people.
While RRSP contributions are tax-deductible, the withdrawals you make aren’t an exemption. Since the contributions are pre-tax dollars, you are taxed on your withdrawals. Even then, there is a withholding tax. Let’s look at the table below:
|Amount:||Withholding Tax Rate in Every Province and Territory Except Quebec:||Withholding Tax Rate in Quebec:|
|Up to $5,000||10%||5%|
|$5,000 up to $15,000||20%||10%|
So, for example, if you are located within B.C. and want to withdraw money, let’s say $2,500 from your RRSP, $250 would be withheld as tax. It certainly is a disadvantage with opening an RRSP because with a TFSA, that $250 would not be withheld at all.
As for the rest of the withdrawal, the total amount of your withdrawal from the RRSP is taxed and therefore added to your earned income on your tax returns. Let’s look at another example of where this is added to the income tax return:
Displayed in the picture, it’s added directly to your net income and then your taxable income. If we wanted to look at what the difference is if the withdrawal was made through a TFSA:
That’s around a $900 difference from switching accounts. Then again, that’s what you will get with a TFSA, and you pay tax now so that you can save later. Whereas with an RRSP, you are going to save now, so you can pay later. However, depending on how you want to strategize your finances, there isn’t a lousy option between these two accounts, despite this example’s roughly $900 difference. And if you consider any higher amounts you may withdraw, it can push you into a higher tax bracket.
Personal Income Tax Returns:
Depending on which account you may select on your income tax returns, there will be an effect you shall see. As I have mentioned above, contributions to your RRSP are tax-deductible. It means that it could possibly result in a tax refund or lower tax bracket, depending on factors like your incomes or credits.
If we assume that Serge has contributed around $5,000 into their RRSP, the contribution, in this case, $5,000, is deducted from their net and ultimately taxable income.
It’s pretty sweet that the RRSP has this advantage, and the TFSA does not have this same advantage. Remember, any contributions that are made into a TFSA are using your after-tax dollars. These are amounts that have already been taxed previously.
So now, let’s look at the difference Serge may pay in taxes in contributing to an RRSP and the TFSA.
This difference is a significant amount. That $1,766 goes directly back into your pocket (because it isn’t taken out in the first place). And by now, you could be convinced to choose an RRSP over TFSA, but I recommend that you take into consideration the taxes on withdrawals through an RRSP. Just some food for thought.
But while you may pay less tax now with an RRSP, you will later, and this is just half of that representation in the photo.
Purchasing a Home or Attending School:
I’m unsure if this may come as a shock for any, but you can actually use your RRSP to help purchase with that down payment on a house. Under the home buyers plan, the government allows you to use up to $40,000 form your RRSP as part of the funding to purchase a house.
This is restricted to those who are a first-time home buyer. Yet, this $40,000 is also required to be put back into your RRSP within around 15 years if I’m correct. So basically, you are taking an interest free loan from yourself, and contributing the principle back into your RRSP for future growth!
As well, there’s something called the lifelong learning plan, which would allow you to fund part of your education costs for yourself or your spouse or common-law partner. Again, you would withdraw the amounts from your RRSP. The total amount that can be contributed is $10,000 per year and can be attributed to either training or funding.
At the end of the day, this can go a long way for someone if they plan to do either of these activities.
This is going to be a noticeable difference, but I want to talk about it nonetheless. The purpose of each investment account is vastly different from another. This is why it is essential to carefully consider which one will provide the most benefit to you and your investment goals.
An RRSP is designed for you to pay fewer taxes now so that you can take in these contributions with a strive of confidence but pay the taxes later (and possibly more tax than a personal account). Now, there are certain annuities that you can invest in, which will help reduce the amount of tax you pay.
But the general concept here is that you are rewarded now and pay later for your contributions.
Where the TFSA is the opposite, you pay now so that you will be rewarded later. The purpose, or one of them, for the TFSA, is to set your retirement up beautifully by growing your investments over a long period and withdrawing the amounts without any tax repercussions. A tax repercussion with the TFSA will be discussed momentarily.
But overall, as you can see, these purposes are different and will affect you and your future very differently from what could happen.
Did you know that your employer will match the RRSP contributions you make? It’s true, and while not every employer offers this benefit, it certainly seems worthwhile to look into as a result. It’s free money at the end of the day.
There is something called a group RRSP, which allows your employer to contribute a certain amount to your RRSP every year. But how much is that amount? Well, it all depends on their policies and how they structure them. You will often see employers state they will contribute a percentage of your salary to the RRSP. Maybe it’s 2-4%. Possibly higher, maybe lower.
But the basis here is that you can reduce that RRSP contribution room so you can use the funds to contribute to your future. However, the contributions that are made from your employer are added to your earned income, which would be added to your net income.
You would still be able to receive a deduction from the amounts they contribute, but the addition to your income and the deduction would therefore offset each other out. So then, basically, you are receiving free contributions for nothing. So, that’s still a pretty good bargain for me if I do say so myself.
It also seems that employers can opt to have a group TFSA, which would allow the employer to contribute to the TFSA on their behalf. The same rules apply. Any contributions from the employee or employer would reduce the contribution room. And, of course, there would be no effect on the personal income taxes of the employer, other than probably adding the contributions to their income.
Thus, making a difference, very slight, in the reflection of your income taxes.
This withholding tax is based on dividends rather than the withholding tax on withdrawals from an RRSP. There is a 15% withholding tax on U.S. dividends. Yes, that’s right, it’s 15%.
So if you were to own a stock listed on the New York Stock Exchange, maybe Amazon, for example, and if Amazon pays a dividend of $0.80 per share, then $0.12 ($0.80 x 15%) would be withheld from you.
This withholding tax is very annoying, to say the least because there certainly are great U.S. investments, just as there are Canadian ones and all Canadian investors want to reap the benefits of such investments. However, if you focus on dividend investing into U.S.-based securities, then clearly, the more you contribute to your portfolio, the more you’ll lose to this type of tax.
With an RRSP, there is no such thing as a 15% withholding tax on U.S.-based dividends. Interesting, isn’t it? Well, that’s likely because of the already withholding tax shown above whenever you make some withdrawals. And for that, who would want another tax onto the two taxes you’ll pay for withdrawals?
All in all, this makes dividend investing more lucrative through an RRSP than from what it does through a TFSA, yet, one can still dividend invest in Canadian companies in a TFSA to work around this slight taxation on U.S. based ones.
So, we both understand now that with the RRSP that you have to pay those nasty taxes on withdrawal. But there are certain annuities or funds that you can invest into that are aimed to decrease the amount of tax burden you may face.
Some of the different funds are an RRIF, known as a registered retirement income fund or registered retirement income fund, a variable annuity, or life annuity. Once you turn 71, you are able to speak with a tax or financial advisor for advice on which fund makes the most sense for you and your financial needs.
Obviously, these types of funds are not necessary for TFSAs as when it’s time for withdrawal you can withdraw as much as you want without any tax consequences.
If you’re interested in a thorough review of the annuities mentioned above, let me know and I’ll get one done!
I thought it would be essential to discuss the similarities between these two types of investment accounts to understand what you should know about each.
Investments that Can be Held:
There are similarities in terms of the investments that can be held within both accounts. If you fancy yourself a very low-risk investor, then likely have an interest-bearing investment account is something you may look into. And while, yes, they are generally low risk, you may not earn enough to cover inflation over time.
However, if you want to up your risk and try to invest in the stock market, you can invest in stocks, bonds, ETFs (exchange traded funds), mutual funds, GICs (guaranteed investment certificates) and much more into your investment account.
Most of what you can hold into one account, you can hold into the other.
Contribution Carry forward:
A benefit to both accounts is the single fact that any unused contribution room can be carried forward to future years. That’s right. If you haven’t contributed to either account in the past, there’s no need to fear because all of that contribution room is added up.
So let me use an already existing example from the TFSA article I did a while back:
We have our pal Serge here.
When he turned 18 in 2018, he was getting ready to graduate from high school and ensure he gained admission to a post-secondary school. Investing was the last thing on his mind.
Fast track to 2021, where Serge has graduated from university with a degree in stonks; it was finally time to open a TFSA and start investing for the future.
Serge turned 18 in 2018, meaning he could open a TFSA at that time and begin contributing. During 2018, the annual limit was $5,500. Since he did not contribute any amount, he can carry forward the entire $5,500 for future years.
During 2019 and 2020, the annual limit was $6,000, which is also carried forward for the following years.
As of 2021, the annual limit is also $6,000.
Together, Serge has a total contribution room in 2021 of $23,500. As we know, this means Serge can contribute a total of $23,500 into his TFSA without suffering any penalty and taxes.
Now imagine the same with an RRSP with this example used in my RRSP article:
Here we are just taking some previously calculated contribution room that has been uncontributed and adding them to the beginning of our calculation. It’s easy to follow along, but if you don’t know your unused contribution room, check your CRA account, as they will have a statement that provides the total amount you are eligible to contribute.
So the next and maybe final question how do you choose between the RRSP or TFSA?
Well, while the battle of the TFSA vs. RRSP is based on personal preferences, both of these accounts have their unique advantages, and as established, their differences as well. That’s why it’s essential to look at these differences in taxes, contribution amounts, and employer matching to genuinely analyze what could be best for you.
At the end of the day, the use of both accounts can help an individual pay less marginal tax in their own unique ways. Just consider carefully whatever you feel will best suit your needs in the future and the present.
I hope you have found some benefit to this article and if you have, let me know in the comment sections below.
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