Two of the main self-funded retirement vehicles which Canadians use are the Tax-Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP). The RRSP was introduced in 1957, while the TFSA was introduced in 2009. The RRSP is typically known as the investment account you use to save for retirement, but a TFSA may be the correct choice for your situation.
So TFSA vs RRSP for retirement savings, let’s see which is best for you!
How does an RRSP work?
An RRSP account can be opened once you start earning income from employment or certain other sources. Your RRSP contribution room is the lower of 18% of your previous year’s income or the specified maximum ($30,780 for 2023), subject to certain adjustments, usually for work pension contributions. Your unused contribution room is carried over each year, so it keeps building. One of the main benefits of an RRSP is the contributions are tax deductible. For example, if you make $80,000 a year and you contribute $10,000 in one year, your taxable income will be reduced to $70,000 and your taxes payable will be reduced by roughly $3,000. Your tax deductions go against your marginal tax rate, not your average tax rate. Another main benefit is the growth within your RRSP is tax-sheltered. When you withdraw money from an RRSP, at any time after contributing it or in retirement, both your contributions and growth will be treated as taxable income. Presumably, your retirement income is lower than your earned income over your career, resulting in a net benefit to you over the years.
How does a TFSA work?
A TFSA can be opened by all Canadian residents who are 18 or older. There is a specified contribution amount each year, but you can carry forward the unused contribution room up to your lifetime maximum. Contributions to a TFSA differ from an RRSP as there are no tax deductions, however the growth within your TFSA is tax-free, and when you withdraw from your TFSA there are no taxes to pay whatsoever. For example, if your TFSA is valued at $50,000 and over 30 years it grows to $150,000, you can take out the full $150,000 without paying taxes.
When an RRSP may be better
You are self-funding your retirement
If you are like most Canadians, you won’t be part of a pension plan through work. That means you have a greater responsibility to save towards retirement. Building up an RRSP over your working career means you get tax deductions on your contributions and will receive a stream of income each year in retirement. RRSPs by design are rolled over to a Registered Retirement Income Fund (RRIF) in retirement (or at the latest age 71) when the government specifies you start taking out at least the minimum each year. You will also need RRSPs as a mainstay because only saving in your TFSA, will not get you the retirement income you need to survive.
Your income is higher while working than in retirement
A key factor with RRSP contributions is determining if your income is likely to be higher when you are contributing compared to what it will be in retirement. RRSP contributions are tax deductible against your marginal tax rate. If you make $130,000/year, your marginal tax rate is roughly 43%. If you contribute $10,000 in a year, your taxable income would be lowered to $120,000 and you would lower your taxes payable by $4,300.
If you will be receiving roughly $65,000/year in retirement, your marginal tax rate would roughly be 30%. If you withdraw $10,000/year in retirement, that would increase your taxable income to $75,000 and you would have taxes payable on that additional withdrawal of $3,000. The net difference is $1,300 in your pocket.
You lack financial discipline
A TFSA is a lot easier to access your money from. Since your withdrawals aren’t taxed and you get your contribution room back the following calendar year, it may feel easy to take out lump sums. On the other hand, an RRSP withdrawal has taxes withheld on the withdrawal. If you want to take out $50,000 for example, the withholding tax is 30%. You would need to take out $71,429 to receive $50,000 in your bank account, given $21,429 (30%) would be withheld for tax purposes. I’m addition, you do not get to re-contribute those funds back into the account at a future date. That may be the incentive an individual needs to not make any lump-sum withdrawals throughout their working career.
When a TFSA may be better
The TFSA is generally misunderstood. A lot of individuals think of it as a savings account as opposed to an investment account. Some situations where a TFSA contribution makes more sense are listed below.
Your current income is low/lower than in the future
If you are in a lower marginal tax bracket, contributing to a TFSA probably makes sense over an RRSP contribution. If, for example, you’re making $45,000 in a year, you would be in a marginal tax bracket of 20%, meaning a $10,000 RRSP contribution would lower your taxes payable by $2,000. Given the tax deduction isn’t at a high rate and you may have a salary increase later in your career (which means a higher marginal tax rate), TFSA contributions would make more sense at a lower income.
You have a pension through work
When you have a pension through work, you will receive a pension income which is taxable in retirement. Let’s say you receive a pension income of $55,000 each year, and between Old Age Security (OAS) and Canada Pension Plan (CPP) your income from them is another $20,000. This would mean your base taxable income in retirement is $75,000. Given RRSP withdrawals are taxable, this leaves you with a higher tax rate in retirement. If on the other hand, you had built up your TFSA throughout your career, all withdrawals are tax-free, keeping you with $75,000 taxable income even with a $20,000 TFSA withdrawal in one year.
You may want to access the money before retirement
When you withdraw from a TFSA, the withdrawal is tax-free. If you take out a lump sum when you are 50 to help purchase a cottage or a car, the TFSA would make the most sense. The next calendar year you would get your contribution room back. If you were to withdraw a lump sum from your RRSP when you are 50 to purchase a cottage or a car, there will be withholding taxes on your withdrawal, it would be treated as taxable income, and you would lose that contribution room.
Keep in mind that TFSA money can always move to an RRSP, if it makes tax planning sense down the road.
So…which one is best for you?
These have been a few main examples of when it would make sense to invest in one account over the other. It may seem confusing which account is best for you as everyone’s situation is unique. It is beneficial to put a plan in place with a professional to guide you along the way. A lot of individuals will end up using both accounts at different times throughout their working life. A change in jobs, from a job with no pension to a job with a pension (or vice versa), may mean a change in the account you’re contributing to. One of the most important aspects of investing is to start early and stay invested long-term.
This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances.