When the Tax Free Savings Account was introduced in 2009, there was a lot of excitement, and a lot of questions. In 2019, as we have just passed the 10-year-anniversary of this account, there are still a lot of questions which need to be answered around the TFSA, especially in comparison to the RRSP.
Focusing on Retirement
The first things which needs to be determined is the reason why you need to save money.
If you are primarily concerned with retirement income, an RRSP may be a better option as your savings focus. While unused contribution room from previous years carries forward for both TFSAs and RRSPs, retirement plans have higher annual contribution levels. RRSPs also allow some income-splitting strategies for married couples with spousal RRSP plans in place.
The TFSA, however, still has a place in retirement plans, and in some cases may have the advantage.
Withdrawals from RRSPs are taxable income, meaning you are taxed on the amount you take out. With RRSP’s the assumption is that when you are retired you will be earning less income than you would be during the years that you are contributing to your RRSP, so when you begin to withdraw funds, you will be in a lower tax bracket, thus taxed at a lower rate.
In comparison, TFSAs are built with after-tax dollars, so when it is the right time to withdraw money from a TFSA, the CRA does not view it as income, and will not tax it. Another point worth noting is that if your RRSP income is high, you may lose some government support of CPP and OAS (Old Age Security), whereas TFSA withdrawals have no such impact.
Investing your savings with interest income sheltered from tax is naturally a good idea, and both TFSAs and RRSPs offer shelter, each with its own features. TFSA contributions provide no immediate tax relief. You cannot deduct these from your tax return in the year you contribute. RRSP contributions, on the other hand, defer tax on the amounts contributed, reducing your taxable income, and creating potential tax refunds in the current year. At retirement, withdrawals from your RRSP are taxable, so if your overall income is lower at retirement, RRSP funds are taxed at a lower rate, under Canada’s progressive tax system. This includes both contributions and investment income. TFSA contributions are made with income already taxed, and the big advantage of a registered TFSA is that investment income earned in the account grows tax-free, both annually and at withdrawal.
Behavioural Savings Impact
One of the key features of the TFSA is flexibility. The account is designed as a general-purpose savings vehicle that allows investment growth without erosion from income taxes. You can withdraw from a TFSA at any time with no impact on your income, and you can even top up your TFSA to replace withdrawals from previous tax years. An RRSP is less forgiving. Withdrawals are taxed, so if you dip into RRSP savings before retirement, that is income on top of regular income, so your tax burden increases. For impulse spenders, TFSA flexibility may be a disadvantage, as there is nothing to keep you from withdrawing and interrupting investment earnings on those dollars.
Generally, investments allowed in both TFSAs and RRSPs are similar, and include cash funds, guaranteed investment certificates, government and corporate bonds, mutual funds and stocks. Both savings plans prohibit investments that are not at arm’s length from the investor. A significant difference is how the Internal Revenue Service in the United States taxes dividends paid to Canadians from ownership of American stocks. The IRS considers RRSPs as a tax deferral account and allows dividend payment on a tax-free basis. Since a TFSA is a general-purpose account, dividends on U.S. stock are subject to withholding tax at the time of payment.