A Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP) are registered savings accounts made available to Canadians who want to grow their savings long term without the burden of taxation.
The intended purpose of each account varies, and it may or may not be what you need. Let’s analyze the main differences between both accounts, compare their pros and cons, as well as review the reasons why you would want one over the other.
Key Takeaways
- The biggest differences between a TFSA and RRSP are their purposes, how they’re taxed, and the withdrawal rules for each account.
- TFSAs use after-tax dollars and grow tax free. You can withdraw anytime.
- RRSPs use pre-tax dollars and also grow your savings tax free, until retirement when you’re taxed on withdrawals.
- Both TFSAs and RRSPs have yearly contribution limits.
Overview of TFSA vs. RRSP
Before we discuss the pros and cons of a TFSA or an RRSP, and which one you should choose, here’s a quick overview of what they are.
What is a TFSA?
TFSA stands for Tax-Free Savings account. This is a kind of registered savings account available to all Canadians, created back in 2009. The main purpose of this account is to help Canadians grow their savings tax free.
This doesn’t mean that you will not pay taxes at all. In the case of your TFSA, the money you deposit is taxed. But, it will be allowed to grow tax-free (with some exceptions). And once you decide to take your cash out, you won’t pay taxes on it.
What is an RRSP?
A Registered Retirement Savings Plan (RRSP) is another kind of registered savings account available to Canadians. Its main purpose is to help Canadians save money for their retirement.
Just like a TFSA, an RRSP helps to make your savings grow tax-free. But unlike a TFSA, your RRSP savings are taxed when you withdraw your funds.
However, when you do retire, you will likely be in a lower tax bracket, and potentially save even more on taxes.
A comparison of features
Here’s a look at the features of each plan side-by-side:
| Feature | TFSA | RRSP |
|---|---|---|
| Main tax saving strategy | * Deposits count towards your taxable income * Your savings grow tax free, and you aren’t taxed on withdrawals |
* Pay less taxes in the short term by reducing your taxable income * Your deposits grow tax free, and you’re taxed when you withdraw (usually at retirement when you’re in a lower tax bracket) |
| Contribution limit | $7,000 in 2024, but depending on your personal contribution room, it could be a lot higher than that | 18% of your previous year’s income or $30,780 (the lesser of the two) |
| Investment vehicles | * Cash * GICs * Stocks * Bonds * ETFs * Mutual funds |
* Cash * GICs * Stocks * Bonds * ETFs * Mutual funds |
| Tax deductible contributions | No | Yes |
| Withdrawal limits | * Withdraw funds tax-free anytime * The amount withdrawn gets added to your contribution limit for the next year |
* Depending on your RRSP, you can withdraw before age 71, but you’ll be charged withholding tax * Once you reach 71, you must withdraw a minimum amount |
| Main problem it aims to solve | Incentivize you to save for mid-to-long term goals | Save for your retirement |
Pros of TFSAs vs. RRSPs
Let’s compare the main benefits of a TFSA vs. the benefits of an RRSP.
Pros of a TFSA
- Tax-free growth: Earnings within a TFSA (interest, dividends, and capital gains) are not taxed, even upon withdrawal.
- Flexibility: You can withdraw money from a TFSA at any time for any purpose without tax implications, which makes it highly flexible for short-term or long-term goals.
- No impact on government benefits: Withdrawals from a TFSA don’t count as income, so they don't affect eligibility for income-tested government benefits and credits.
- No age limit: Once you turn 18, there’s no age limit for contributing to a TFSA. You can contribute as long as you have available contribution room.
- Carry forward contribution room: Unused contribution room can be carried forward indefinitely, allowing you to catch up in future years.
Pros of an RRSP
- Tax deductions: Contributions to an RRSP reduce your taxable income, potentially resulting in a significant tax savings.
- Tax-deferred growth: Investments in an RRSP grow tax-free until withdrawal, usually in retirement when your income (and tax bracket) may be lower.
- Retirement savings: RRSPs are specifically designed to encourage long-term savings for retirement, helping to ensure financial security in your later years.
- First-time home buyer and education withdrawals: The Home Buyers' Plan and Lifelong Learning Plan allow for tax-free withdrawals for specific purposes, under certain conditions.
- Spousal RRSPs: Contribute to a spousal RRSP to split income in retirement, potentially lowering the overall tax burden for a couple.
Cons of TFSAs vs. RRSPs
Below we list out the main downsides of each registered savings account.
Cons of a TFSA
- Contribution limits: Depending on how much you want to save, and how much contribution room you have, your annual contribution limit can be lower than you hoped. If this situation applies to you, you could be better off contributing towards an RRSP, which has a higher limit.
- Exceeding your limits has penalties: If you happen to exceed your TFSA contribution limit, you will be taxed 1% on the excess amount per month. It’s a lot easier than you think to exceed your limit, especially if you’ve made contributions recently.
- Fewer tax benefits: Unlike an RRSP, any money you place into a TFSA doesn’t reduce your taxable income for the year.
- Flexibility is a double-edged sword: Being able to withdraw funds from a TFSA so easily is also a downside. This could tempt some people to withdraw funds on impulse to purchase a want, thus harming their long-term savings goals.
Cons of an RRSP
- You will be taxed each time you make a withdrawal: Withdrawals from an RRSP are subject to withholding tax and income tax. The rates depend on how much you withdraw, where you live, and your income level.
- There are limits to your contribution: Although the annual contribution limit for an RRSP is quite generous for most Canadians, for some it’s not. If you happen to exceed your contribution limit, there are tax penalties, just like with a TFSA.
- Required withdrawals: Your RRSP needs to be withdrawn, converted to a Registered Retirement Income Fund (RRIF), or put into an annuity when you turn 71. At that point, you will have mandatory minimum withdrawals, which will then be taxed as income.
- Your RRSP withdrawals could impact government benefits: Because any RRSP withdrawals are considered income, they could affect your eligibility for certain benefits in retirement, such as the Guaranteed Income Supplement (GIS).
Reasons to choose a TFSA
TFSAs are a great choice for you if you’re considering the following:
- Saving up for a rainy day.
- Saving up for a big purchase other than a home.
- You plan on maxing out your RRSP but want to put away even more funds for your retirement.
- You want to invest in stocks, bonds, or other securities and enjoy tax-free growth.
Reasons to choose a RRSP
An RRSP is a great choice for you for the following reasons:
- You and/or your spouse want to save for your retirement.
- Your job offers RRSP contribution matching.
- You want to reduce your taxable income and avoid paying a higher tax rate.
- You want to make a larger contribution than what’s possible on a TFSA.
Do you prefer a TFSA or RRSP?
Choosing between a TFSA and RRSP becomes easier to do the more you learn about them. And hopefully this article has made it easier for you to choose whether to get a TFSA, an RRSP, or both.
Which account do you prefer and why? Or do you use both? Let us know your strategy in the comments section below.
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Should I invest in a TFSA or an RRSP?
It depends on what your main goals are. If you’re looking to save for your retirement, an RRSP might be your best choice. If you want to save for a car or a dream vacation, you may be better off with a TFSA.
What's the difference between a TFSA and an RRSP?
Contributions to a TFSA are made with after-tax dollars and there are no penalties charged for making withdrawals. With an RRSP, your contributions are tax deductible and you pay taxes on future withdrawals.
How much of your salary should you contribute towards your RRSP or TFSA?
There is no one-size-fits-all answer here. It’s wise to consider the yearly contribution limits of each account and budget according to your personal circumstances. What really makes the difference is consistency.
Is it better to keep your money in a savings account or in a TFSA?
In many cases it might be a TFSA. It lets your deposits grow tax free, and you can invest in an array of securities. The majority of savings accounts don’t offer that. However, savings accounts don’t have contribution limits.
Can you withdraw money from your TFSA whenever you want?
Yes. In fact, this is one of the main benefits of a TFSA. And whatever you withdraw also gets added to your contribution room for the next year.
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Comments
I tend to contribute to my RRSP with my employer matching only and focus the rest of my money elsewhere. I sometimes will make an extra contribution to bring my income down close to the 45-50K range before I drop into a lower tax bracket.
I think I'm going to save most of my room for the next while until my income gets much higher and focus on the TFSA for a while.
Good rule of thumb Sean, thanks!