You have a job, you are saving part of your income, and your hard-earned money is sitting in the same savings bank account you opened years ago. You may have noticed that the interest your money is earning has been dwindling while the fees the bank charges you remain the same. Perhaps you have heard about other savings accounts like Tax-Free Savings Accounts (TFSA) and Registered Retirement Savings Plans (RRSP), but you are unsure how they work or what they are.

Both accounts are superior savings accounts versus the traditional bank “savings” account; however deciding whether to put your money into a TFSA or RRSP is not straightforward. It really depends on the purpose for which you are saving, your current marginal tax rate, and your work pension. All combine to determine which type of account would be more beneficial. As a quick starting point, you do not buy RRSPs or TFSAs.  Think of them more as buckets that you can put money into and then purchase investments or assets like stocks, bonds, mutual funds, exchange traded funds (ETFs), etc. Let’s dive a bit deeper into each type of account to better understand both before determining which is better for you.

The Registered Retirement Savings Plan: these plans were announced in 1957 to encourage self-employed people and companies’ employees to save for their retirement. Since then, the RRSP has gained popularity and has become the cornerstone of many Canadian’s retirement planning processes.

How does an RRSP work? You can contribute to an RRSP with after-tax dollars and that money can then grow tax free for use in retirement. Remember that bank savings account we discussed earlier? Well, you are taxed on the income that it generates at your highest marginal tax rate. We have a graduated tax rate system in Canada meaning that as you pass the threshold of each income bracket you pay more in taxes. Any interest your savings account generates is included as income when you file your taxes.

In contrast, the income earned in an RRSP is not taxed and can remain in your account to earn you more money. Over time your RRSP investment compounds. Compounding means that the money your RRSP earns is re-invested and makes you more money, accelerating your savings rate over time.

Also, when you contribute to an RRSP the government will give you back the taxes paid on those contributions in the form of a tax refund. Here is an example of how this works.
Let’s say you make $60,000 per year. That means you would have paid $10,757 in income taxes. These taxes were probably deducted from your pay at source, meaning your employer would have held these taxes back when they paid you and remitted them to the government on your behalf. Your take home or after-tax income is $49,243 based on your marginal tax rate (29.65% in Ontario). For every dollar you earn the government will take at least $0.2965 of that in taxes. What happens if you make an RRSP contribution? Well,  the government will refund the taxes paid on your behalf by your employer based on your RRSP contribution amount. If you contribute $5,000 over the year to your RRSP you would receive a $1,482 tax refund. 

If you would like to play around with the numbers and see the impact, here is a great calculator from EY. (All the above references are using Ontario tax numbers.)

https://www.eytaxcalculators.com/en/2020-personal-tax-calculator.html

A very important note on the RRSP is that the money contributed should remain in the account and not be withdrawn. If the money is withdrawn from the account, the government will ask that taxes be refunded to you be repaid.

Once you turn 65 years of age and retire, you can convert the RRSP to a Registered Retirement Income Fund (RRIF), which pays out annual income. You can delay the conversion until 71, but that is the latest an RRSP can be converted to an RRIF. There is also the first-time home buyers’ program in Canada that allows up to $35,000 to be withdrawn from an RRSP without penalty for the down payment on a Canadian’s first home purchase.

Other than at 65 or for your first-time home purchase, money withdrawn from a RRSP will be taxed at your marginal tax rate. Therefore, a RRSP is not the best place to be saving for things like a car, wedding, or vacation. There are also different RRSPs; Spousal RRSPs, Group RRSPs and Pooled RRSPs (Pooled and Group RRSPs are generally offered through your work). The final thing to note is  the amount you can contribute to an RRSP is 18% of your previous year’s salary subject to a maximum cap set out by the government ($26,500 for 2019). Any unused contribution ‘room’ is then carried forward indefinitely. If you have not contributed to a RRSP yet, do not worry, you have not missed out.

The Tax Free Savings Account:  This account type is much more flexible than a RRSP. Like a RRSP, you contribute after tax dollars to a TFSA and all income generated in this account is not taxed at year end. In-fact it is never taxed, even upon withdrawal. Also, there are no restrictions on how long the money must remain in a TFSA before it can be withdrawn. The amount that can be saved in a TFSA is prescribed by the government every year.

In 2020 the amount that can be contributed is $6,000. This amount also accumulates if the contribution room is not used. There are province-to-province age restriction variations versus an RRSP. RRSP contribution room is determined based on income earned from working, whereas TFSA contribution room accumulates due to age. In Ontario once you turn 18 your TFSA  starts accumulating contribution room. For example, if you were born in 1989 and have never contributed to a TFSA, you have $69,500 in contribution room for 2020. If you were born later, you will have to calculate your contribution room based on the government’s annual contribution amounts each year.

https://www.ratehub.ca/investing/tfsa-contribution-limit

If you are looking to save for a vacation, car, wedding or even topping up a down payment for a house then a TFSA may be a better option vs a bank savings account or an RRSP.

Your pension is another factor to consider when deciding whether a TFSA or RRSP is a better option. If you have a defined benefit pension plan (DB)that will pay 80%-90% of your final 5 year working salary, then an RRSP might not be the best savings vehicle as your marginal tax rate will not decrease that much in retirement. If you have a defined contribution pension plan (DC), your employer is essentially setting up a retirement savings plan for you and deciding how to invest those funds. A DB or DC contribution from your employer will reduce the amount you can contribute to an RRSP, but not a TFSA.

Overall a TFSA is the more flexible option and allows tax exempt withdrawals at any point during the life of the account. An RRSP is great if you are earning more income now versus in retirement or are looking to compound the RRSP’s tax advantage. One strategy we use with clients is to contribute up to $35,000 into an RRSP for the down payment on their first home. We then invest the tax refund they receive from those contributions into a TFSA to further compound the amount they can put down on their first home.

While which type of savings vehicle is best for you is not straightforward, this article should give you more information to better maximize your TFSA and RRSP accounts. If you can maximize contributions to both, that is ideal and you are ahead of most Canadians in terms of saving for retirement.

When trying to decide which account to use for saving, first think about your financial goals:

• Saving for retirement;
• Down payment on your first home;
• Funding a Vacation or Car?

All are worthy and important milestone goals to plan for.  Next think about your current and future tax rate will it be higher or lower in the future at retirement? Even though there are trade-offs, this is a great starting point in assessing the correct account.

There are many factors to think about and some tradeoffs to be made, so if you have any questions on which might work best for you please let us know. We would be happy to help.