Should I Contribute To My RRSP or my TFSA?

The differences, pros and cons of these popular registered accounts

The Registered Retirement Savings Plan (RRSP) and it’s younger sibling the Tax-Free Savings Account (TFSA) are two of the most popular tax options for the average Canadian. Before deciding which, if either, to contribute to, here’s a primer on how they work, and what they’re best for.

What is a Registered Account?

Both the RRSP and the TFSA are what’s called registered accounts. What all registered accounts tend to have in common is that growth within these accounts is tax-free. This means that any assets stored inside an RRSP or TFSA can earn interest, dividends or capital gains without impacting your tax bill.

This can be an important factor, particularly in long-term strategies, such as saving for retirement. Every year your investments grow tax free, you’re keeping more of those assets and therefore have more available to reinvest. Tax free earnings therefore have a higher rate of return, in practical terms, than taxed earnings. Year after year after year, that higher return compounds and can make a substantial difference when it’s time to retire.

Tax-Free Savings Account (TFSA)

A TFSA’s main property is its simplicity: assets held within one, as with all registered accounts, grows tax-free. There are no tax implications at the time of contribution, nor at the time of withdrawal. These transactions aren’t recorded in any way on your tax return.

Each Canadian over the age of 18 earns some contribution room each year according to the government’s rules (usually between $5,000 and $6,000 annually). Your available contribution room at any given time is your total lifetime contribution room minus any contributions you’ve made in the past.

The withdrawal/recontribution rules can be a little confusing, however. When you make a withdrawal from your TFSA, you do get that contribution room back…but not until January of the following year. Meaning if you have maxed out your TFSAs and have $0 contribution room left, and then you withdraw $1,000, you still have $0 contribution left. But as of January of the following year, that space opens up again and you have that $1,000 worth of room back, along with the new year’s contribution allowance.

Don’t contribute to your RRSP until you read this!

Registered Retirement Savings Plan (RRSP)

The RRSP differs from the TFSA mainly in how contributions and withdrawals are handled. Unlike a TFSA, there is an immediate tax benefit to contributing to an RRSP. Funds contributed to an RRSP are eligible for a tax deferral, meaning that they remove some of your income from the tax calculation. So for example, if you earn $50,000 and put $5,000 in an RRSP, you’ll be taxed as if you only earned $45,000.

However, it is only a deferral, not a permanent exemption from tax. When you withdraw funds from an RRSP, generally the deferral ends and at that point the income becomes taxable. So at some future time when you withdraw your $5,000 again, you’ll be taxed as if it’s new income, based on whatever your tax rate is at the time.

The advantage of the deferral is that you can make a contribution to defer tax when your tax rate is high (i.e., when your earnings are high), and make a withdrawal when your tax rate is low (i.e., when your earnings are low). The assumption is that RRSP contributions are made during your highest-earning years, while the withdrawals happen after retirement when your income is presumably lower. But in reality you can make withdrawals at any time you think it’s necessary or strategic to do so.

Another difference between RRSPs and TFSAs is how the contribution room is handled. Contribution space depends on your earnings. Every year you get additional contribution room equal to 18% of your prior-year’s earnings, up to an annual maximum. Unlike a withdrawal from a TFSA, where you get the contribution room back after a delay, once you make a withdrawal from an RRSP you never get that contribution room back.

(Note that in some cases, such as the Home Buyers’ Plan (HBP) and the Lifelong Learning Plan (LLP), you can make a withdrawal from your RRSP but keep the tax deferral going, subject to certain repayment rules.)

What Happens to the Money You Repay to Your Home Buyers Plan (HBP)?

TFSA or RRSP?

So when do you contribute to your RRSP and when do you contribute to your TFSA?

TFSAs are good when your income isn’t high enough to make the RRSP contribution worthwhile. For example, someone with a very low income who inherits (inheritances are not taxable when they’re received) a significant amount that they want to use to start an investment portfolio might be advised to contribute to a TFSA rather than an RRSP: The RRSP’s tax deferral is less effective when income, and therefore the tax rate, is low. Meanwhile the TFSA’s tax-free withdrawal rules mean it’s easier to get at the funds if they’re suddenly needed.

RRSPs are best when your income is robust or when you’re experiencing a spike in income that is pushing some of your income into a higher marginal tax rate. A contribution to your RRSP can be used to shelter your most heavily-taxed dollars, and you can always withdraw them later in a year where you need the money more – usually because you’re earning less, and your tax rate is lower.

Conclusion

Both TFSAs and RRSPs get a lot of their power from their ability to increase your assets in the long term. Because of the contribution room rules, however, they are poor vehicles for transferring money in and out frequently. It’s advisable to make contributions you expect to ‘park’ for at least a year, ideally many years so you can get the most out of them.

If you do have long-term investments, it’s advisable to have them in registered accounts as much as possible. There is no substitute for tax-free income, so if you’ve got assets available to invest, they should be contributed to a registered account unless and until you’ve used up all your available contribution room. But which type of account to use depends on your situation and your goals.