RRSP vs. TFSA: which one is for you?

Fuller Landau Team • February 17, 2021
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There are two powerful investment options that can help Canadians save for retirement: Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TSFA). The question that often comes up – which one is right for me? In short,  it depends on a variety of circumstances and will change as your life changes. Understanding the differences between these two options can help you determine which one is best suited to meet your needs.

Registered Retirement Savings Plan (RRSP)

Any resident of Canada for tax purposes that has earned income and has filed income tax returns in Canada is eligible to contribute to an RRSP until the end of the year you turn 71. Your earned income for RRSP purposes generally includes your employment earnings, self-employment earnings and net rental income, less employment expenses, and any business or rental losses.

Earned income does not include most types of passive income, such as interest, dividends, and capital gains. More information on how to calculate your earned income is available here.

Generally, the amount that you are able to contribute is the lesser of 18% of your earned income for the previous year and the annual contribution limit for the year. For the 2020 tax year, the contribution limit is 18% of the earned income reported on the prior year’s tax return, up to a maximum of $27,230. If you have an employer-sponsored pension plan such as a registered pension plan (RPP) or defined profit sharing plan (DPSP), your RRSP contribution limit is reduced by the pension adjustment. The pension adjustment is disclosed on your T4 slip. Any unused contribution room from previous years can be carried forward and added to your current year’s contribution room. Be sure to monitor your contribution room closely. Contributing more than your limit will result in having to pay a tax equal to 1% per month on amounts that exceed your limit by $2,000.

The contribution deadline for the 2020 tax year is March 1, 2021 (60 days after the end of the year). You can find your contribution room here.

You may also contribute to your spouse or common-law partner’s RRSP. However, these contributions are limited by your own contribution room as they reduce your RRSP deduction limit. The amount contributed to a spousal RRSP creates a deduction for the contributor (you) and not your partner.

One of the major advantages of an RRSP is that your contributions are tax-deductible against your income and investment income earned within your RRSP will not be taxed. However, keep in mind that any amount withdrawn from the RRSP will be subject to income tax.

There are some exceptions. Tax-free withdrawals from an RRSP are possible if you are a first-time home buyer. The Home Buyers’ Plan (HBP) allows you to withdraw up to $35,000 from your RRSP to purchase or build a housing unit in Canada if you did not occupy a home that you owned in the four-year period prior to the home purchase. You must pay back the withdrawn funds within 15 years. The minimum annual repayment amount is one-fifteenth of the total amount withdrawn. If you pay less than what is required for a year, the difference will be included in your taxable income.

You can also withdraw up to $10,000 in a calendar year from your RRSP tax-free under the Lifelong Learning Plan (LLP) to finance full-time training or education for yourself or your spouse/common-law partner. You must pay back the withdrawn funds within 10 years. Similar to the HBP, any annual shortfall of the repayment is included in your taxable income.

Tax-Free Savings Account (TFSA)

The TFSA is available for individuals aged 18 or older with a valid social insurance number (SIN). Regardless of whether you file a tax return, you will accumulate TFSA contribution room each year from the date TSFAs were introduced in 2009 or since you turned 18, whichever is later. You may open as many TFSAs as you like, but your contributions must not exceed your limits. If you exceed your contribution limits, you will be required to pay a tax equal to 1% of the highest excess amount contributed, for each month the excess amount remains in the TFSA.

For the 2020 tax year, the contribution limit for a TFSA is $6,000, in addition to any unused contribution room from previous years.

Click here for the annual TFSA dollar limits for all previous years. You can also find your contribution room on CRA My Account.

As the name suggests, investment growth within a TFSA is not subject to income tax. Unlike with an RRSP, a contribution to a TSFA does not provide a tax deduction but a withdrawal from a TSFA is also not added to your taxable income. In addition, making a withdrawal does not cause a loss of contribution room. Any amounts withdrawn in the year will be added to your TFSA contribution room at the beginning of the following year and can be redeposited to your TFSA at that time.

RRSP vs. TFSA – which one is for you?

Which is the better option for you? It depends on various factors, including your individual financial situation, goals, timeline, and more.

Generally speaking, you may be better suited for an RRSP if you are in a higher income tax bracket now and expect to be in a lower income tax bracket in the future when you plan to make withdrawals. That way, you are getting a reduction on your taxes at a higher tax rate and being taxed on that amount at a lower rate. You may also want to consider using an RRSP if either you or your spouse/partner has a significantly higher income than the other. The ability to contribute to your partner’s RRSP provides income splitting opportunities, since the contribution is deducted from the contributor’s income while the eventual withdrawal is taxed in the lower income spouse’s hands.

On the other hand, you may be better suited for a TFSA if you are currently in a lower tax bracket or you expect to be in a higher tax bracket at the time of withdrawal. If you are currently subject to low marginal income tax rates, the tax savings on the RRSP contribution will not be as valuable and it may be advantageous to save the RRSP contribution room for later.

It is also worth considering which one to use based on the type of investments you’re choosing. In the case of U.S. stocks, unlike RRSPs, the Internal Revenue Service in the United States doesn’t recognize TFSAs as a retirement account. Therefore, U.S.-sourced investment income earned in a TFSA is subject to non-resident withholding taxes.

You may also want to factor in whether you are planning for long-term or short-term savings. TFSA may be better for short-term savings (i.e., for a down payment, vacation, car, etc.). Since there are no tax considerations on withdrawal and the contribution room gets restored, there is more flexibility in the short-term.

Since one’s life circumstances are almost never static, the choice between RRSP and TFSA shouldn’t be either. Please contact our Tax team if you have any questions regarding RRSPs and TFSAs.

About the authors

Jessica Li is a Junior Tax Specialist on our Tax team. She can be reached at jeli@fullerllp.com or 647-417-0401.

Dylan Chen is a Senior Tax Specialist on our Tax team. He can be reached at dchen@fullerllp.com or 647-417-0410.

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