Tax Time: Four Questions to Help You Decide Between RRSPs and TFSAs

RRSP
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Are you confused about the difference between an RRSP and a TFSA?

If the answer is yes, you’re not alone. Toronto-Dominion Bank’s survey last month indicated that about one in four Canadians don’t understand the difference between the two savings plans, says TD’s Jenny Diplock, associate vice-president, personal savings and investing.

READ: Tax Time: Should You Contribute to an RRSP or Pay Down Your Mortgage?

As the March 2 deadline to contribute to a Registered Retirement Savings Plan (RRSP) draws ever nearer, many are wondering whether they should put money there, or into a tax-free savings account (TFSA).

While most financial advisors recommend using both, you may only have a limited amount to put away and might want to understand which is the best savings plan.

It can get complicated, so don’t beat yourself up if you’re confused, says Toronto-based certified financial planner Alexandra Macqueen. Here are the major questions to ask yourself, she suggests:

  • What is the money for (a shorter-term goal, like buying a house or car, or a long-term, such as retirement)?
  • What is my income now?
  • What will it be when I retire?
  • Do I qualify for income-tested benefits (now, such as the Canada child benefit now, or in retirement, like the Guaranteed Income Supplement)?

A Primer

Here’s a quick primer on the basic differences as they relate to your taxes:

RRSP: The amount of money you put in an RRSP reduces the income the government taxes that year; in other words, you pay less tax up-front. But when you take that money out, you get taxed on what you take out. “The idea being that in your retirement if your income is lower, you pay less tax on the money when you withdraw it,” than you would have while earning more, says Diplock.

TFSA: The money you put in a TFSA does not reduce your taxes that year, but you pay no tax on what you withdraw. In other words, you pay less tax on the back end. “The wealth that you grow within the TFSA is tax-free,” says Diplock. This is helpful if you need the money while still in higher-earning years, for a goal such as buying a car or a wedding.

Contribution limits: While there are pros and cons to each savings plan, the contribution limits may not give you a choice as to which plan you put money into, over a certain amount. For TFSAs, it is currently $6,000 a year, while for RRSPs it is 18% of your 2019 earned income, up to the maximum of $26,500 (this amount is set each year by the Canada Revenue Agency). You can find your amount on your previous year’s income tax notice of assessment.

Penalties: If you go over how much you are allowed to contribute, you will be taxed on that, by about 1% a month.

What is the money for?

Shorter-term goal: “TFSA tends to be used for more short- or medium-term goals,” says Diplock, such as buying a car or paying for a wedding. You can take money out without paying taxes on it. You can also pay that money back in to the TFSA, up to your contribution room.

With an RRSP, you would be taxed on the amount you withdraw. There are a couple of exceptions. One is if you withdraw money from an RRSP under the Home Buyers’ Plan.

What is my income now?

Which savings plan you choose to contribute to for the long-term goal of retirement, depends on a variety of scenarios.

Low-income scenario: “If your income is low [under $40,000 to $50,000], the relative benefit of participating in the RRSP is low,” Macqueen says. “If you’re in a low-income [tax] bracket, the tax refund is going to be very small. So it doesn’t really make much difference. You’re not getting a significant refund for making that contribution. Then on the other side, when I withdraw it in retirement, it’s going to eat away at the [government] benefits I would have otherwise received.

Average middle-class earner: “Your average middle-class worker who might be earning $50,000 to $70,000, if they have less income in retirement because they don’t have a defined benefit pension, then they could use an RRSP,” says Macqueen. “They will get the tax refund when they are contributing and then adding the taxable income to their other [government] income in retirement.”

Gig workers: “One of the things we learned in [the TD] survey was that a lot of gig economy workers do prefer a TFSA and found that it gave them more flexibility because you have access to the funds without any tax implications,” Diplock says, adding it can act as a kind of “safety net for times when they may not have steady income or they could have fluctuations in income because they work a seasonal job.”

High-income scenarios need to take into account future-income predictions and government benefits.

What will my income be when I retire? and Do I qualify for income-tested benefits?

Income in retirement and the amount of money you can get from the government in income-tested benefits are related.

Income-tested benefits: People may be eligible for more or fewer government benefits based on their income in retirement. These include Old Age Security (OAS) and the Guaranteed Income Supplement (GIS).

It can be difficult to predict your income and how much you will be taxed, says Macqueen. Here are a couple of situations that illustrate how different scenarios might play out.

High-income scenario: “I have a lot of income when I’m working and then for whatever reason have a lot of income while retired,” says Macqueen. “Maybe my RRSP grew really significantly, maybe I inherited my husband’s RRSP and now I’ve got his as well as mine, maybe I’ve got a fantastic defined benefit pension that’s paying me a lot in retirement. In that case, you’re going to lose a lot to tax” when you start to withdraw the money from your plan, which you are required to do after turning 71.

You will also get less from the government through clawbacks. “I would have qualified for OAS, but it starts to be clawed back once my income is above [about] $75,000.”

But if you’re not in a defined benefit pension plan, even if your income is high, “earning $130,000 to $150,000, those RRSP contributions are very attractive. They lower your taxable income today, you get the immediate benefit back to your pocket and at retirement, if all your income is coming from your personal savings plus CPP and OAS … you’re probably not going to hit the OAS clawback,” she says, “as long as you can manage to keep your income under $75,000.”

Low-income scenario: If you would have low income in retirement, but when you withdraw money from an RRSP, it increases what the government sees as your taxable income, you may lose the GIS you would otherwise have received, says Macqueen. But the money in TFSAs has already been taxed, so it is not counted toward your taxable income when you withdraw it in retirement, so it would not have the same effect on additional government benefits.

Bonus question: What kind of funds should I put in each different savings plan?

While most people know you can put all kinds of investments into an RRSP, “I think there’s actually a misconception that a TFSA is just a savings account,” Diplock says. Like an RRSP, you can put most types of investments in a TFSA, from guaranteed investment certificates (GICs) and bonds, to stocks and different types of funds.

As for which savings plan to use for interest-bearing investments (such as bonds and GICs) versus investments that grow through capital gains (such as stocks and equity funds), there are arguments for both, says Macqueen.

“Some people say that because interest is fully taxable, you should put interest-bearing investments into a TFSA” because you will not have to pay tax on the interest growth. On the other hand, “capital gains are taxed at half the rate of interest and… equities have a higher expected return than fixed income or things that generate interest,” and you don’t pay taxes on that bigger growth when you withdraw money from a TSFA. (What you withdraw from an RRSP is taxed the same, regardless of whether it is interest income or capital gains on a stock.)

Make a plan

Each person’s finances are different, so both Macqueen and Diplock recommend creating a plan with a financial advisor that takes into account the specifics of your own situation.

“For the most part, neither contribution will be a bad idea. They are both savings,” Macqueen says.

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