RRSP vs TFSA

Unsure about whether to invest your money in an RRSP or TFSA? Both investment options offer tax advantages, but they work quite differently. Let’s explore which account may be more suitable for your situation and how you can maximize their benefits.

Balance Your Tax Savings While Saving for Retirement

What’s the best money habit you can have? Saving before spending. This approach means setting aside part of your paycheck before you spend it on anything else. While the amount of personal debt is rising, there’s also some positive news regarding saving trends in Canada.

Statistics Canada reported that in 2018, 20% of income earners saved nearly $41,393 per household. Then came the COVID-19 pandemic, which, even with its struggles, brought some surprising financial shifts. Along with more family time, remote work, and online shopping, savings habits improved dramatically. Actually, Canadians managed to save five times more in 2020 than they did in 2019.

While growing your savings is beneficial, there's an even smarter financial strategy to consider — saving money while cutting down on your taxes.

How Do You Save on Taxes?

You can't avoid paying taxes on money you earn or items you buy. But the government has created ways to lower your taxes. They do this to encourage people to save funds and invest them in specific ways.

You can lower your tax burden by depositing funds into specific types of accounts. In Canada, the two main options are RRSPs and TFSAs. You also have the option to use both account types to optimize your tax savings. Let's take a closer look at RRSPs and TFSAs to see how they can help you retain a larger portion of your earnings.

What is an RRSP?

An RRSP or Registered Retirement Savings Plan is a savings account that enables you to set aside money for your retirement. You can contribute to this account each year until you reach the age of 71. Your final contribution must be made by December 31st of that year.

Once you turn 71, you'll need to move your RRSP funds into a RRIF (or Registered Retirement Income Fund). However, you don't have to wait that long to make the switch. If you retire earlier, you can convert your RRSP to a RRIF at any point after you turn 65, which is when many people traditionally stop working.

RRSPs come in a few different forms to suit your situation. Moreover, you're not limited to just one RRSP. You can have several different RRSP accounts simultaneously. The simplest type is an individual RRSP, which is solely yours.

Another option is a Spousal RRSP, in which one partner owns the account while the other partner contributes the money. This works for both married couples and common-law partners.

If your workplace offers one, you might have access to a group registered retirement savings plan. This is a retirement savings plan that your employer sets up. You can contribute to it through your salary.

The important thing to remember is your total RRSP contribution room. This is the maximum amount you can put into all your RRSPs combined each year. 

For instance, if your yearly limit is $6,000, you could split it among your registered retirement savings plans. You might allocate $2,000 in your personal RRSP, $1,500 in your group plan, and $500 in a Spousal RRSP. Just make sure the total amount stays within your $6,000 limit.

What are the Tax-Saving Benefits of an RRSP?

Once you understand the basics of RRSPs and their different types, let's explore how they can help you save on taxes.

• RRSPs offer tax protection on your money. When you deposit funds into an RRSP, they become sheltered from taxes. Regular savings accounts require you to pay taxes on the interest you earn, but with an RRSP, these tax charges don't apply as long as your funds stay in the account.

• Your RRSP withdrawals are likely to be taxed at a reduced rate. This is because your overall income during retirement will probably be less than it is currently, so you'll pay lower taxes on money taken from your RRSP. Therefore, an RRSP helps you save on taxes in your later years as well.

• An RRSP lets you benefit from tax-free compounding interest to increase your retirement savings.  This means you earn interest on your interest and that growth is free from taxation.

• A Spousal RRSP offers tax advantages both in the present and during retirement. You can contribute part or all of your RRSP contribution room to a Spousal RRSP owned by your lower-income spouse or partner. This provides two key benefits: first, when your spouse withdraws the funds in retirement, they will be taxed at their lower income rate. Second, the higher-income partner gets a tax deduction for the contribution. With a Spousal RRSP, you reduce the overall tax paid during retirement years.

What is Your RRSP Limit?

You can contribute up to 18% of your earnings from the previous year into your RRSP. However, the maximum limit changes each year due to inflation. In 2024, the maximum contribution you can make is $31,560, regardless of whether your 18% exceeds that amount. 

You must be cautious not to contribute too much money. The government provides a small buffer in case you make a mistake — an additional $2,000 above your limit. If you exceed this figure, you will incur a monthly fee of 1% on the excess amount. Moreover, this buffer does not qualify for tax deductions. These charges can accumulate quickly, so it's critical to monitor your RRSP contributions throughout the year. 

At the same time, unused contribution room from previous years can be carried forward. This will allow you to contribute more in the future.

What is a TFSA?

Now, let’s explore Tax-Free Savings Accounts (TFSA). A TFSA allows you to save money and avoid taxes on your earnings. However, you can apply for it only if you are 18 or older and have a valid Social Insurance Number. TFSAs, like RRSPs, also enable you to carry forward any unused contribution room to future years. If you don’t use your entire limit in one year, you can use it in later years. For example, if you only contribute $4,000 in 2023, your contribution limit in 2024 will be the standard $7,000 plus the remaining $2,500 from 2023.

There is a total lifetime limit that gets adjusted from time to time as well. As of 2024, if you have been eligible since the establishment of TFSAs in 2009 (meaning you were at least 18 years old at that time) and haven’t made any contributions yet, you can put in as much as $95,000 in total.

Keep in mind that to open a TFSA or benefit from tax savings, you have to be a current Canadian resident. Non-residents can keep existing TFSAs, but new contributions are subject to a 1% monthly penalty. If you have moved outside of Canada but want to keep the tax-free status of your account, you cannot contribute any more funds without a penalty. Once your Canadian residency is reestablished, you may continue using your account and regain access to all the benefits.

What are the Tax-Saving Benefits of a TFSA?

Let's explore the tax advantages a TFSA can provide:

• Your TFSA funds are sheltered from taxes. Any earnings you make on your TFSA are completely free from taxation.

• With a TFSA, the tax savings continue when you take funds out. Unlike a regular savings account where interest earnings are taxed each year, a TFSA allows your money to grow tax-free — and you won’t pay any taxes when you take it out.

• You can begin saving on taxes when you turn 18. Establishing good saving habits early on is important, and with a TFSA, you can begin lowering your tax obligations as soon as you qualify. Plus, any unused contribution room keeps adding up each year. As your income increases, you can contribute bigger amounts.

What is Your TFSA Limit?

For the year 2024, the government permits you to contribute up to $7,000 to your TFSA. If you’ve been eligible since TFSAs were introduced in 2009 (which means you were at least 18 years old at that time) and haven’t made any TFSA contributions so far, you’ve accumulated $95,000 in total contribution room.

This larger total amount comes from summing up all the annual limits since 2009. The government reviews and adjusts the annual limit every few years to align it with inflation, always increasing it by $500 at a time.

It's essential to monitor how much you contribute. Exceeding your limit can lead to major expenses since the government imposes a fee of 1% per month on any contributions that go beyond the limit.

When should you contribute to an RRSP or TFSA? 

Trying to choose between an RRSP or TFSA? This is a frequent question, and the choice largely depends on your current financial situation and your future plans. Although both types of accounts let you reduce your tax obligations, they do so in different ways.

When to Contribute to an RRSP

Registered Retirement Savings Plans are most effective when your current income places you in a higher tax bracket than you expect to be in during retirement. They're especially valuable if you earn more than $50,000 annually and want to reduce the amount of income tax you pay each year. If your employer provides an RRSP as part of your benefits, these accounts become even more appealing because that's essentially free money for your retirement. You can contribute to an RRSP for a specific tax year up to 60 days into the following calendar year. This is why the RRSP deadline is usually around March 1st every year.

When to Contribute to a TFSA

In general, Tax-Free Savings Accounts work well for achieving both short-term and long-term savings goals at different stages of life.

• Early career and lower income years. TFSAs fit individuals in the early stages of their careers who expect their income to grow in the future. With a TFSA, you can earn interest tax-free while preserving your RRSP contribution room for when your income increases and tax deductions become more beneficial. This approach allows you to maximize your tax savings over time.

• Flexible savings and emergency fund. TFSAs are also ideal if you want flexibility in accessing your savings with tax-free withdrawals. This allows you to create an emergency fund or save for major purchases while continuing to earn tax-free investment returns.

• Retirement planning and higher income years. This account type is a good choice if you plan to work during retirement or expect substantial retirement income from other sources, as withdrawals won't affect your tax bracket or government benefits.

• Contribution room and withdrawals. Unlike an RRSP, when you withdraw money from a TFSA, you get that contribution room back the following year, giving you the flexibility to replace savings when you’re able.

RRSP vs TFSA: Which Has Better Tax Benefits?

Looking at both RRSPs and TFSAs, it's clear they each offer great tax benefits. Not sure which one to pick for your retirement savings? You don't need to choose just one! You can actually use both an RRSP (even several of them) and a TFSA to build your savings. The main thing to consider is whether you'll have more or less income in retirement than you do while working.

In general, RRSPs are a good option if you're certain that you won't need to access these funds until retirement. But remember, they also offer an amazing benefit through the Home Buyers' Plan if you intend to buy your first home. Additionally, the Lifelong Learning Plan allows you to withdraw funds for education or training, making RRSPs a flexible tool for major life investments. 

With Home Buyers Plan, you can temporarily borrow up to $60,000 from your savings for retirement and pay the funds back during the next 15 years. 

When you contribute to an RRSP, taxes are deferred until withdrawal. The amount you keep depends on your tax rate at retirement:

Since many retirees fall into a lower tax bracket than during their working years, withdrawing from an RRSP often results in lower tax payments.

With a TFSA, contributions are made with after-tax income, so withdrawals remain tax-free. If your income is expected to increase in retirement, a TFSA may be the better choice:

A tax-free savings account ensures that, regardless of tax rate changes, withdrawals remain untaxed, making it a strong option for those expecting higher income in retirement.

Interested in learning more about using TFSAs and RRSPs to reduce your taxes? Get in touch with us today!