RRSP or TFSA? Which is best for you?

Most Canadian investors have asked themselves this question at one time or another. In general, the answer is an unsatisfying – it depends!

The reality is that, depending on your goals and stage of life, either one or both may be optimal for you. There are so many variables that can be at play in any individual’s financial situation, that there just isn’t a one size fits all answer to this question.

As you often hear in the personal finance world – personal finance is personal!

One thing is for certain, though, as investors we are super lucky to have both these options available to us.

The Registered Retirement Savings Plan (RRSP) and the Tax Free Savings Account (TFSA) each come with their own pros and cons. One may be better suited for you in helping you work towards your financial goals given your current stage of life. Over time, though, you may find it beneficial to switch your focus from one to the other, or you may find that the RRSP and TFSA work well together in a complimentary way.

Just the facts.

The goal here is to highlight details about the TFSA and RRSP that are important for any investor to know. So, whether you are trying to decide which account to prioritize OR you plan to max out your contributions to both accounts (GREAT!), it will be important for you to understand these key aspects of each account.

Please keep in mind that I’m not a financial advisor or an accountant, and I’m not recommending a particular course of action. I’m simply reviewing the facts regarding each account type and sharing some aspects of my experience based on having invested in both RRSPs and TFSAs over many years.

What’s up with the RRSP?

The RRSP has been around for much longer than the TFSA, having been created in 1957 through an amendment to the Income Tax Act. Rules relating to RRSPs have evolved over time, and generally these changes have made the RRSP more flexible and useful for Canadians looking to save for retirement.

Key aspects of RRSPs:

Contributions reduce taxable income. You may be entitled to a tax refund depending on how much you contribute.
Assets grow on a tax deferred basis. This means no tax is payable on interest, dividends, or capital gains earned from assets held in an RRSP. Note that dividends earned from foreign stocks (excluding US stocks) may be subject to withholding tax.
Annual contribution limit: 18% of prior year income, to a maximum of $31,560 (for 2023). The maximum increases each year based on inflation.
Unused contribution room carries over to the following year.
Amounts withdrawn are treated as income in the year of withdrawal.
Withdrawals do not affect available contribution room.
Assets that can be held in an RRSP include: stocks, bonds, exchange traded funds (ETFs), mutual funds, money market funds, GIC’s, high interest savings accounts (HISAs).
The RRSP must be converted to a Registered Retirement Income Fund, or RRIF, by the end of the year in which the owner turns 71. Can be converted prior to 71 as well. You can simply transfer your existing holdings into the RRIF account with no tax implications.
Once converted to a RRIF, contributions are no longer permitted and minimum annual withdrawals are required starting the year following conversion.
At death, the balance of the RRSP or RRIF can be transferred to a spouse on a tax deferred basis.
If there is no spouse, the remaining balance will be withdrawn and treated as income on the final tax return. After tax balance will go to the estate.

The RRSP is a great tool for building retirement wealth over time. One of the key concepts is that you contribute to an RRSP in your earning years while your income is high, and those contributions reduce your taxable income. Then you tap your RRSP for income during your retirement years, when your income is lower, and as a result, your marginal tax rate is lower as well.

In addition, there are two unique withdrawal programs available with RRSPs.

Home Buyers Plan (HBP)

The HBP provides the RRSP owner with the option to borrow up to $35,000 (as of 2023) from their RRSP for the purchase of a home. The loan is interest free and there is no tax payable on the amount withdrawn. Repayments must start after 2 years, and the loan must be fully repaid over the following 15 years.

This is a great option for first-time home buyers, although the maximum amount you can borrow hasn’t really kept up with the increase in housing prices over the years.

Lifelong Learning Plan (LLP)

The LLP offers the RRSP owner the flexibility to borrow funds from their RRSP to help pay for their post-secondary education. Up to $10,000 per year can be borrowed, and the maximum amount that can be borrowed under the LLP is $20,000. The amount borrowed must be repaid within 10 years after the completion of the education program.

The TFSA – the newer kid on the block.

The TFSA is the newcomer, having been launched in 2009.

Key aspects of the TFSA include:

Contributions are made with after tax You won’t get a tax refund as a result of contributions to a TFSA.
Assets grow tax-free! No tax is payable on interest, dividends, or capital gains earned in a TFSA. Note that dividends earned from non-Canadian stocks, including US stocks, will be subject to withholding tax.
Withdrawals are tax-free!
Annual contribution limit: $6,500 (for 2023). The maximum increases periodically, usually in $500 increments, indexed to inflation.
Unused contribution room carries over to the following year.
Annual and cumulative TFSA contribution limits since 2009 inception:

Withdrawal amounts are added back to available contribution room the following year. So, you don’t lose contribution room when you make a withdrawal.
Assets that can be held in a TFSA include: stocks, bonds, exchange traded funds (ETFs), mutual funds, money market funds, GIC’s, high interest savings accounts (HISAs). Same as an RRSP!
At death, the full remaining balance will go to your beneficiary, or estate, tax-free!

Although contributions to a TFSA are not tax deductible, this investment account gives you a lot of flexibility, in addition to the ability to grow investments tax free.

Some people have mentioned that the name for this account, Tax Free Savings Account, was a poor choice because it implies that the account is like a bank savings account where you earn interest on the funds you deposit. The reality is, though, that once you contribute money to your TFSA you then need to put it to work by buying some type of investment such as stocks, bonds & GICs, an ETF, or mutual funds.

Don’t forget this important step, otherwise you’ll just have a bunch of lazy money sitting in your TFSA!

Summary of Pros and Cons for the RRSP and TFSA.

Now that we’ve covered the details, let’s summarize some of the Pros and Cons for RRSPs and TFSAs.

RRSP Pros:

Contributions reduce taxable income and may produce a tax refund.
Annual contribution maximum amounts can be much larger vs. the TFSA (depending on income).
Taxes are deferred on capital gains and income.
Owner can determine timing and amount of withdrawals (subject to required minimums once converted to a RRIF).

RRSP Cons:

Withdrawals are taxed as income.
Full remaining balance will be taxed as income upon the death of the owner unless transferred to an eligible spouse.

TFSA Pros:

No tax on capital gains, income, or dividends from Canadian companies.
Withdrawals are tax free.
Contribution room is re-gained in the calendar year following a withdrawal.
Owner can determine timing and amount of withdrawals.

TFSA Cons:

Contributions are not tax deductible.
Tax will be withheld US on dividends.
Annual contribution limits can be lower compared to the RRSP (subject to income level).

So, which one is best?

Once again, it depends!

These are both great options for building wealth over time. The ideal situation is that you can max out contributions to both accounts. This is not always possible, though, especially if you’re early in your career and/or trying to balance multiple priorities in life.

If you have to pick just one to invest in for now, here’s some factors to consider.

Low or low-moderate income.

Generally speaking, if your income is lower then the tax deduction from RRSP contributions will be less valuable to you since your tax rate will already be fairly low. As a result, the TFSA might be the best option because you’ll enjoy tax free growth of your investments and if you need to make a withdrawal you can do so tax free without giving up contribution room (which you would lose with an RRSP).

In addition, if/when your income increases in the future, you can always move funds from your TFSA to your RRSP and enjoy the reduction to your taxable income and potentially a tax refund.

Moderate to high income.

If your income is already moderate or high, the tax deduction resulting from contributions to an RRSP can be quite significant. For example, an Ontario resident earning $90,000 a year with $10,000 available to invest would reduce tax payable by approximately $3,025 (in 2023) by investing the $10,000 in an RRSP.

Tax savings will vary depending on your province of residence.

In addition, the higher your income, the larger your potential savings. To expand on the example above, an Ontario resident earning $150,000 would save roughly $4,341 in taxes (in 2023) by investing the same $10,000 in an RRSP.

Those are significant tax savings! Saved tax dollars will be able to compound in your RRSP potentially for decades.

Tax savings and the ability to contribute larger amounts makes the RRSP a great long-term wealth building tool.

Saving for a major purchase or the unexpected.

The TFSA can be a great place to build an emergency fund or to save for a larger purchase. If those are key goals for you right now, then the TFSA might be the best option, even if your income is high.

The flexibility of the TFSA makes it a great investment account option, and those annual contributions over 30+ years will really add up.

The Bottom Line.

The RRSP and TFSA are both great investment account options for building retirement wealth over time.

Their unique attributes can also make them very useful for saving for specific goals such as buying a home or paying for education. The TFSA in particular can also be a great option for saving for an emergency fund or for a major purchase.

As an investor, our best course of action is to reflect on what our current goals and priorities are and then select the account type that will be best suited in helping us achieve those goals.

All the best on your wealth building journey!