Pick the Right Investment Plan for You: TFSAs vs RRSPs

What are TFSAs and RRSPs?

TFSA stands for Tax-Free Savings Account, and RRSP stands for Registered Retirement Savings Plan. Both are registered accounts designed to help your savings grow through different kinds of tax incentives.

What are some similarities between TFSAs and RRSPs?

• Both are registered savings accounts created by the federal government to help Canadians save for retirement or other goals.
• They both offer tax-related incentives for putting aside money for the future.
• They are tax-sheltered savings accounts that can hold various interest-generating investments (like cash, stocks, bonds, GICs, etc.). 
• They need to be set up with a financial institution as a specific kind of account.

What is the difference between a TFSA and an RRSP?

One of the biggest differences between TFSAs and RRSPs is in when the tax incentives apply.

With an RRSP, you deposit pre-tax money and then you get to claim a deduction on your tax return that lowers your taxable income. Who doesn’t love a tax refund, right? As long as that money is in your account, you don’t have to pay tax on any interest, dividends, or capital gains you earn. But you do have to pay income tax on the money once you start making withdrawals. In other words, it’s a way to defer taxes, or put them off until later.

With a TFSA, you don’t get a tax deduction—any deposits you make are from after-tax income. But when it comes time to take money out, those withdrawals are tax-free, no matter how much you earned. It’s a pretty sweet deal, really.

One fact to remember: Just because one of these accounts has “retirement” in the name and the other has “savings” doesn’t mean that’s what they’re best used for.

Many people use TFSAs to save for retirement, and while RRSPs are primarily meant for retirement savings, it’s common to “borrow” money from your RRSP account for education costs (the Lifelong Learning Plan) or a down payment on your first home (the Home Buyers’ Plan).

Here are some more facts about TFSAs and RRSPs.

TFSA basics

• The government sets an annual contribution limit (it’s $6,500 in 2023), and everyone who’s 18 or older and a tax resident of Canada is eligible to deposit up to that amount, whether or not they filed their taxes.
• If you don’t contribute in any particular year, you can still deposit that amount (plus the new year’s contribution limit) the following year. In other words, contribution limits accumulate, which is an amazing deal you should absolutely take advantage of.
• If you were already 18 in 2009 (when TFSAs started) and have never had a TFSA, your total contribution room would now be $88,000. If you’re younger than that, you can calculate your maximum by adding up each year’s annual limit since the year you turned 18, based on this list of past annual limits.
• See your contribution limit on your Notice of Assessment or by logging in to your CRA My Account.
• The money that goes into your TFSA is after-tax—you don’t get a tax deduction from TFSA contributions.
• You can withdraw the money you put in, plus any earnings you make on that money, at any time without having to pay any tax.
• If you take money out of your TFSA, you regain your contribution room as of January 1st of the immediate following year.

You can read more here: How the Tax-Free Savings Account (TFSA) Actually Works

RRSP basics

• Your annual contribution limit (also called a deduction limit) is based on your income. Each year, you can contribute 18% of your income, up to a maximum that the government sets. (In 2023, that maximum is $30,780, which is 18% of $171,000.)
• Any contribution room you don’t use rolls over to future years. 
• See your contribution limit on your Notice of Assessment or by logging in to your CRA My Account.
• The money that goes into your RRSP is pre-tax. If you make an RRSP contribution, it lowers the amount of income tax you have to pay.
• If you take money from your RRSP to pay for eligible education costs or a down payment on your first home, you can “borrow” that money rather than withdraw it. This means you don’t have to pay tax on the withdrawal, but you do have to repay that money within a certain amount of time.
• You can only have an RRSP until the last day of the year you turn 71. At that point, you must either withdraw the entire amount (and pay tax on it) or turn it into a Registered Retirement Income Fund (RRIF) or annuity, which are ways to distribute your retirement income over a longer period of time.

You can read more here: 12 Benefits of Investing in an RRSP

Case study

Let’s look at an example of how these accounts work. Take Min Jung—they are a 26-year-old mechanic in New Brunswick who earns a salary of $40,000 per year. According to our income tax calculator, they’ll pay an estimated $8,272 per year in income tax and CPP/EI premiums, leaving them an annual take-home income of $31,728. They have no other income or relevant deductions or credits and has never had a TFSA or RRSP before. 

This year, Min Jung plans to put aside $3,600, or $300 a month.

If Min Jung puts that $3,600 in a TFSA, their deposits come from after-tax income. It won’t lower their tax bill. Here’s the math when we subtract that from their annual take-home income:

$31,728 – $3,600 = $28,128

If Min Jung puts that $3,600 in an RRSP, though, their deposits come from pre-tax income. In other words, they can claim the RRSP tax deduction to lower their taxable income. Here’s what that math looks like:

$40,000 – $3,600 = $36,400

If we plug those numbers back into our income tax calculator, their total taxes and premiums add up to $7,285. Here’s how that translates to after-tax income:

$36,400 – $7,285 = $29,115

To recap, if Min Jung puts their $3,600 into a TFSA, they’re left with an after-tax income for the year of $28,128. If they put that money into an RRSP, they’re left with an after-tax income of $29,115. That’s a difference of $987, or $82.25 per month. The RRSP seems like the best option, right?

But wait. What about future Min Jung? Fast-forward 40 years or so, and Min Jung is ready to hang up their coveralls so they can spend more quality time on their holodeck. (We’re going to have holodecks by then, right?) Over all that time, their $3,600 has been growing by 5% a year, compounded annually. 

Plug those numbers into a compound interest calculator, and you’ll see that after 40 years, that $3,600 has turned into $25,344. 

If it’s in a TFSA, future Min Jung can take that money out any time they like, tax-free. If it’s in an RRSP, they’ll have to pay income tax on any withdrawals. How much income tax depends on their total annual income when they make the withdrawal and the income tax rates that apply at that time. 

If future Min Jung’s tax rates are high when they pull that money out, they’ll be thanking past Min Jung for choosing a TFSA and sacrificing that $82.25 a month to think of the future. 

On the other hand, if future Min Jung’s tax rates are low, or they pay no tax at all, then they’ll be glad they chose an RRSP and spent that $82.25 on other things or even added it to their savings.

Which makes more money: a TFSA or an RRSP?

TFSAs and RRSPs both have the same potential to make money. The difference is you get to choose when you pay the income tax related to these savings.

Remember that TFSAs and RRSPs are both investment accounts, not investments per se. You can hold different kinds of investments in either of them, usually a combination of cash in high-interest savings, stocks, and bonds, either sold on their own or in a mutual fund or exchange-traded fund (ETF). 

So long as your investments and their earnings are held inside your TFSA or RRSP account, you don’t have to pay tax on them. The same goes for any withdrawals from your TFSA—they’re not taxable. But you do have to pay tax on any money you take out of your RRSP, now or in the future.

Because RRSP contributions lower your taxable income, you can, in theory, afford to invest slightly more than if you put after-tax income into a TFSA. But since RRSP withdrawals are taxable, you will likely have to pay part of those earnings to the government eventually. So, it’s a choice between paying income tax now or paying income tax later. Which one makes more money for you depends on the income tax rates applicable to each scenario.

As you can see in this chart, if the tax rates are the same, the end result is the same.

How do I choose between a TFSA and an RRSP?

Is it better to invest in a TFSA or an RRSP? The answer depends on your financial situation—and remember, you can always choose both! 

Here are four factors to consider.

1. Know your investing goals

What are you saving for? Common goals include retirement, education, a house purchase, or an emergency fund. For the latter, a TFSA is the best choice, as taking money out at any time is easy. But for the other three, either option could work. 

If you do want to use your RRSP to save for education or to buy your first home, make sure you understand the rules of the Home Buyers’ Plan or Lifelong Learning Plan. If you’re saving for your first home, you might also want to consider the new First Home Savings Account (FHSA), which launched on April 1, 2023.

2. Assess your current and future income

The government is going to get its share of your money. The only question is, will it be now or later? If you put your savings into a TFSA, you’ll pay the tax now. If you put them into an RRSP, you’ll have to pay later.

Which one makes the most sense for you depends in part on how much tax you’ll have to pay, and that depends on your tax bracket now and in the future. Remember that RRSP contributions lower your taxable income, while RRSP withdrawals increase your taxable income. 

In brief: the more you make now, the more you’ll benefit from the tax savings you get from RRSP contributions. But the more income you think you’ll have later, the more tax you’ll have to pay then—and remember, it’ll be on all your withdrawals, including your contributions and earnings. (Also, your future taxable income will include all sources of income, not just your RRSP.) 

With a TFSA, you pay tax immediately, but no matter how much you make from that account, you won’t have to pay tax on it again. The recommendation is usually to choose to pay the tax at the time you’re in a lower tax bracket. Whether that’s now or in the future depends on your life situation.

There’s another factor to consider: you can make RRSP contributions now and defer the tax benefits until later. This might be a good idea if you think your income will go up significantly.

3. Understand your financial habits

How disciplined are you with money? If the temptation of cash sitting in an account is hard to ignore, an RRSP might be a better choice for you than a TFSA. That’s because you know that if you take money out of your RRSP, you’ll have to pay tax on that amount, whereas, with a TFSA, there’s no tax penalty for withdrawals.

4. Check your workplace for perks

“Never turn down free money” is an excellent rule to follow in life, and one place to look for it is at work. If your employer offers top-ups for RRSP or TFSA contributions, take advantage of them. There’s no better way to earn money on your investments, and since these plans usually come with automatic paycheque deductions, it’s an easy way to save. The specifics of how these top-ups work might affect whether you choose an RRSP, TFSA, or both.

Case study

Let’s look at an example. Mohammad and Andrea both live and work in Surrey, B.C. If Mohammad makes $65,000 per year and puts $10,000 into his RRSP, he pays income tax on only $55,000. Similarly, if Andrea earns $260,000 per year and puts $10,000 into their RRSP, they pay income tax on $250,000. 

But that doesn’t mean they save the same amount of money on taxes. Mohammad is in a lower tax bracket than Andrea, so he would have paid less tax on that $10,000 than Andrea would have. 

The specific numbers depend on the province you live in and what the rest of your tax return looks like, but if you look at federal tax only (for the 2023 tax year), Mohammad’s $10,000 would be in the 20.5% bracket and Andrea’s in the 33% bracket. 

According to B.C. taxes, Mohammad would pay 7.7 % on that $10,000 and Andrea would pay 20.5%. That means Andrea, a high-income earner, gets a much greater immediate benefit from a $10,000 RRSP contribution than Mohammad, who is in a lower tax bracket.

Fast-forward to future Mohammad and future Andrea and their future tax brackets. If Andrea has saved a ton of money and plans to live it up in retirement, they might have a higher income per year than Mohammad, who prefers a simple life. That means Andrea will probably be in a higher tax bracket than Mohammad and will have to pay the government a larger percentage in income tax when making withdrawals.

TFSA or RRSP: The bottom line

When you think about how much you’ll actually end up making on your investments, the difference between a TFSA and an RRSP really comes down to whether you pay the income tax now or later. 

But the most important factor is that you’re saving money at all. 

Create a strategy for putting money aside, and you’ll come out ahead in the end, no matter which type of account you choose. You got this!