Last Updated: June 16th 2020
I am trying to figure out how to say this as plainly as possible while using layman’s terms, so bear with me!
In Canada the Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) are retirement savings plans offered by the government.
It’s main benefit is to help you save, tax-free or tax-deferred. More on that later.
WHAT ARE RETIREMENT SAVINGS PLANS?
It’s where you save money for retirement. Sounds innocent enough right?
What it isn’t, is more important though.
There is no special account called “The TFSA” or “The RRSP” where you save your money.
SO WHERE DO YOU SAVE MONEY IN AN RRSP OR TFSA?
You would typically open an RRSP or TFSA account with a financial institution like a bank.
HOW MANY RRSP OR TFSA ACCOUNTS CAN YOU HAVE OPEN?
As many as you want. As I said, it is not a special account called “The TFSA” or “The RRSP”.
It is just a savings plan under which you save money that you have to declare to the government is earmarked for retirement and tax savings.
HOW IS THE RRSP DIFFERENT FROM THE TFSA?
The RRSP is a tax-deferred retirement savings plan.
The TFSA is a tax-sheltered retirement savings plan.
They sound the same, but the main difference is WHEN you get taxed on your money.
(There are other differences but let’s focus on this one for now.)
If you put money into an RRSP and leave it in there, when you go to withdraw your retirement savings, you will be taxed at the time of withdrawal, like let’s say when you turn 65 and retire.
If you put money into a TFSA and leave it in there, you will pay the taxes at the time you deposit the money, but any profits you make will grow tax-free.
I DON’T REALLY GET IT, WHY DOES IT MATTER WHEN IT IS TAXED?
Imagine you have $100 at the age of 25 to save for 40 years, and at the end of those 40 years, you will have $10,000 due to the magic of compounding interest and proper investments.
Let’s say you want to take out the full $10,000 at the age of 65.
HOW YOUR $10,000 IS TAXED IN AN RRSP
If you had put that $100 into an RRSP, it would have a balance of $10,000 in 40 years.
When you go to take out your $10,000 in 40 years from an RRSP at the age of 65, you will be taxed at whatever income tax rate you happen to fall into at the age of 65.
So let’s say it’s 50% as a tax rate because you ended up making a lot of money at the end of your career.
Your $10,000 will be taxed at that 50% tax rate, so the government gets $5000.
HOW YOUR $10,000 IS TAXED IN A TFSA
If you put that $100 into a TFSA, it would also have the same balance of $10,000 in 40 years.
Same deal as above, but you were already taxed at the time of depositing your money into your TFSA!
So when you go to take out your $10,000 in 40 years from a TFSA at the age of 65, you are not taxed at all.
That’s right. NO taxes, because you already paid them!
Any profits you made from that $100, can be taken out out tax-free.
SO THE TFSA IS OBVIOUSLY BETTER THEN!
It depends on what your situation is, how and when you want to use and withdraw your money, but before I get into that, let’s talk about the other differences between an RRSP and a TFSA.
OTHER DIFFERENCES BETWEEN AN RRSP AND A TFSA
Contribution room = Amount you can save in either plan as there are limits
- Only allowed for those aged 71 and younger
- It is tax-deferred, which means you get taxed at the time you go to take out the money
- Whatever you contribute affects your tax bracket (e.g. it can lower your income so that you pay less taxes)
- All profits you earn in an RRSP can be withdrawn at the time of retirement (age 65)
- The money is of locked in once you contribute
- You can’t withdraw the money early without penalties (10% at a minimum plus paying the taxes)
- Exceptions: You can withdraw the money for a home or education but will have to pay it all back!!
- Any withdrawals at the age of 65, will be considered “income”
- Contribution room is calculated at 18% of your income each year up to a max of $27,230 as of 2020
- Contribution room is also based on EARNED income, which does not include dividends
- Unused contribution room is carried forward to later years, and accumulates.
- You can find out how much contribution room you have in the tax returns you receive every year.
- When you reach the age of 71 you have to convert your RRSP account into a RRIF*
- If you over contribute to an RRSP, you can do so up to a lifetime maximum of $2000 before being penalized
- If you die, you can roll the money over to your spouse tax-free
- If your spouse dies after you, and your children get the money, they will get it AFTER it has been taxed
- You should drain this RRSP ASAP for estate planning purposes once you retire as it is fully taxed* once you die
- *You can help circumvent some of this if you make your spouse (common-law included) in all provinces but Québec as the Successor Annuitant on your RRSP/RRIF not a Beneficiary, or else they will get heavily taxed. In Québec you will need a will for this.
*RRIF = Registered Retirement Income Fund, where the government basically forces you to withdraw the money you’ve saved in your RRSP on an annual basis.
- Only allowed for those 18 years and older
- It is tax-sheltered which means you get taxed at the time you contribute to the TFSA
- Whatever you contribute does not affect your tax bracket (e.g. does not bring down your net income)
- All profits that you earn in a TFSA account can be withdrawn tax-free at any time
- The money is not locked in once you contribute
- You can withdraw the money any time you like without penalties for any reason at all
- ..but you CANNOT re-contribute what you withdrew in the same calendar year*
- Any withdrawals are not considered “income”, as you have already been taxed
- Contribution room is a set dollar amount for everyone each year, regardless of income at $6000 as of 2020
- Contribution room is not based on earned income, it is equal and a fixed amount for everyone
- Unused contribution room is carried forward into later years and accumulates.
- You can find out how much contribution room you have by calling the Canada Revenue Agency
- You do not need to convert a TFSA into anything
- If you over contribute to a TFSA, you are taxed at 1% each month
- If you die, you can roll the money over to your spouse (common-law included) tax-free if you set them up as a Successor not a Beneficiary in any province but Québec (where you need a will that states this) or else they will pay taxes in between the holding period from date of death and when they take it over
- If your spouse dies after you, and your children get the money, there are less taxes than in an RRSP** as TFSAs are not considered taxable
*E.g. if you put in $5000 to max out your TFSA in January 2013, and take out that $5000 in February 2013, you cannot RE-contribute a second time until January 1st 2014, or the next year.
**By minimal taxation, I mean that only the increase in the TFSA in the year of death is taxed in the year your children will receive the money. They aren’t taxed on the full amount, just on the increase in the year of death between the time of death and the date they take over the account as a beneficiary.
The best case scenario is that you max out BOTH accounts, but if that is not in the cards, then read on!
YOU SHOULD MAX OUT YOUR RRSP FIRST IF…
- You are under the age of 18 because TFSAs are only allowed for those 18+
- You are in a higher income bracket where lowering your net income will make a difference (Benchmark: $50,000 gross income)
- If you want to be forced to save for your long-term retirement (age of 65) & lock in it for good
- You want this money to be only for retirement savings
- You have a high income and you want to save on taxes by getting yourself bumped to a lower tax bracket
- You plan on making LESS money in retirement (age of 65), and therefore will be in a lower tax bracket
- You plan on buying a house by borrowing from your RRSP (remember, you’ll need to pay it all back!)
- You plan on investing in U.S. dollar holdings (you have to pay foreign income tax otherwise)***
***This is because Canada and the U.S. have a tax treaty. Canadians can invest in the U.S. stock market under an RRSP and be sheltered from foreign taxes, and Americans can invest in their 401Ks in the Canadian stock market and be sheltered from foreign taxes.
Otherwise, if you hold U.S. dollars outside of an RRSP (even in a TFSA!) you will be taxed on your foreign income.
If you hold U.S. stocks but in a CANADIAN fund, you will get taxed. It’s only if you hold direct, true U.S. stocks or mutual funds in USD that you won’t get a withholding tax.
YOU SHOULD MAX OUT YOUR TFSA FIRST IF…
- Note: You have to be at least 18 years old
- You are over the age of 71, because you are no longer eligible to save in an RRSP
- You are already in a low income bracket (as a student, low-income earner, retiree..) (Benchmark: Below $50,000 gross income)
- You already have a company pension plan that you save into because TFSAs are not considered “income”
- You want to save money but you MAY need it in the short-term and don’t want to lock it in
- You want to have an emergency fund on hand of sorts
- You expect to not have a lot saved at retirement and will rely on government pensions (GIS / OAS)
- You plan on making MORE money in retirement and therefore will be in a higher tax bracket later on
- You want this money to be open for any kind of savings goal you have
HOW I USE MY RRSP AND MY TFSA AND WHERE MY MONEY GOES
I have 4 types of savings:
- RRSP Account – Maxed out (Questrade)
- TFSA Account – Maxed out (Questrade)
- Investing Account – Money I want to invest but cannot put into RRSP / TFSA (Questrade)
- High-Interest Savings Account – In cash for emergencies / living expenses (Tangerine)
Use my Questrade referral ID: o0soehds and get $50 in free trades
At Tangerine, use my referral code: 32726976S1 to get $50 CAD FOR FREE!
As a freelancer who collects dividends instead of a salary, I am not earning an income by Canada Revenue Agency’s standards, so I do not really get RRSP contribution room each year.
My RRSP is to hold long-term investments which are all held in index fund ETFs at Questrade.
I set it and then I forget it, because I just rebalance 3 times a year. Basically anything that will slowly grow and earn interest in the long-term.
I try to put anything like my U.S. stocks in here or U.S. index funds for tax efficiency because I do not pay U.S. withholding taxes under the Canada-U.S. Tax Treaty.
My TFSA is to hold any individual stocks such as ones I plan on making capital gains upon (by selling for a profit, and only 25% of it is taxed) or anything that earns interest slowly in the long-term, or dividends with Questrade.
I DO NOT use my TFSA or my RRSP to hold things like cash, or as a high-interest savings account.
It’s just such a waste of a perfectly lovely tax-deferred / tax-sheltered account.
I also have an Investing account where I hold individual stocks for capital gains and individual stocks for dividend income for the very nice dividend tax credit where you can pay less than $200 in taxes on $50,000 of dividend income, also held at Questrade.
I also hold U.S. individual stocks and U.S.-based (USD) index fund ETFs in here (my RRSP and TFSA contributions are maxed out but very small as a percentage comparison to my overall net worth).
Lastly, I have a High-Interest Savings account at Tangerine where I keep about $20,000 – $30,000 for in between my projects.
(Who doesn’t love free money?)
If you are interested in investing under your RRSP and TFSA, here are some more links to get you started:
Read all about investing here in my Investing Series
I also offer consultations/help as a money and career coach, so if you want me to look at your situation individually and craft a financial plan for you, I can and will. See rates here.
For a good overview of how to manage your money in general, you can check out this book which I made Instagram-style with lots of pictures and visual help/notes to help you understand various financial concepts called Managing Money Like a Boss (general):
If you are a Canadian and want to get into investing (simply put, you can only spend 4 hours a year and be set for life), plus learn what dividend investing is (and how to screen dividend stocks), what a stock stat means, you can check out my second book on Investing Money Like a Boss (Canada):