Should I invest in an RRSP, a TFSA or both?
James Schofield - May 25, 2023
Find out what factors to consider when looking at RRSPs or TFSAs for investment savings.
The introduction of the Tax-Free Savings Account (TFSA) in 2009 was arguably the most important change to the way Canadians save money since RRSPs were launched in the late ‘50s. But the big question on many investor’s minds is whether to invest in a TFSA or the tried-and-tested RRSP, or possibly even both?
Before shedding some light on the question, let’s first get a firm grasp on some of the differences and similarities between both investment vehicles.
Comparing the TFSA to the RRSP
|Registered Retirement Savings Plan (RRSP)||Tax-Free Savings Account (TFSA)|
|Contributions are fully tax-deductible||Contributions are not tax-deductible|
|Contributions can be made until the end of the year in which you turn 71 years of age||Contributions can be made at any time with no age limit (for those 18 years of age and over)|
|Withdrawals are taxed at your marginal tax rate||Withdrawals are 100% tax-free|
|1% monthly penalty for over contributions||1% monthly penalty for over contributions|
|Withdrawals could affect eligibility for income-tested government benefits and credits||Withdrawals will not affect eligibility for Federal income-tested government benefits and credits|
|Unused contribution room is carried forward indefinitely||Unused contribution room is carried forward indefinitely|
|Withdrawals cannot be returned to the RRSP without using contribution room (except for repayments of withdrawals made under home buyers’ or lifelong learning plans).||Withdrawals will be added to the contribution room in the following year.|
Which is the best?
Now that we’ve established their unique characteristics, let’s return to our original question: TFSA or RRSP? On a basic level, looking at your pre-retirement and expected post-retirement marginal tax rates can provide you with an idea of which account type to prioritize for savings. If you expect to be in a lower tax bracket during retirement, investing in an RRSP is generally more beneficial. However, if in retirement you anticipate being in an equal or higher tax bracket than before retirement, the TFSA may be the better choice. Although it’s tempting to settle on a rule-of-thumb, the decision on whether you should use a TFSA or RRSP is not that simple; you need to consider the entire spectrum of financial strategies at your disposal that could ultimately impact your approach.
Even if you anticipate having a lower marginal tax rate in retirement, maximizing your RRSP contributions is not always the most tax-efficient long-term strategy. Since RRSP withdrawals (directly or through your Registered Retirement Income Fund (RRIF) or an annuity) increase your taxable income, withdrawals can cause you to lose certain government income-tested benefits and credits such as the Old Age Security benefit and the Age Credit.
On the other hand, if your expected marginal tax rate in retirement is equal to or higher than during your working years, RRSPs may still be the way to go. For example, if you convert your RRSP to a RRIF at age 65, you can split income with your spouse, and you will both be eligible for a pension tax credit. Using spousal RRSPs allows you to distribute a portion of your taxable income to a spouse with a lower marginal tax rate in retirement, further reducing your tax bill and the likelihood of OAS claw-backs and other income-tested benefits and credits.
So, where does this leave us?
Generally speaking, a TFSA may be better suited for shorter-term goals, such as an emergency fund or saving for a major purchase, since there is no tax on withdrawals and any amounts that come out are added back to the TFSA room the following year. However, RRSPs are generally the vehicle of choice for long-term objectives since there are substantial tax incentives to keep your money invested. The TFSA can also be a powerful retirement savings tool. However, due to the ease with which TFSA savings can be accessed (no taxes on withdrawals or loss of contribution room), only a disciplined investor who can resist the temptation to dip into their savings before retirement fully benefits from a TFSA as a source of retirement income.
Remember, there is no one-size-fits-all solution. In fact, there is a multitude of variables to consider. In many cases, the TFSA should be used as a complementary product, along with your RRSPs, as they both have advantages. Your personal savings strategy needs to take into account your unique circumstances and your short and long-term objectives.