Differences between an RRSP and a TFSA
Since its inception, the goal of an RRSP has been to help Canadians accrue after-tax income to finance their retirement. While a TFSA can also be used to save for long-term needs, the two savings vehicles have important differences:
- Tax deductibility – RRSP contributions are tax deductible and reduce your income for tax purposes. In contrast, TFSA contributions are not tax deductible.
- Contribution limits – You may be able to contribute more to an RRSP—up to 18 percent of your previous year’s earned income or to an annual RRSP dollar limit ($23,820 for 2013) adjusted for certain amounts (e.g., pension adjustment, past service pension adjustment, and pension adjustment reversal). In 2013, the annual TFSA dollar limit is $5,500. In future years, the annual TFSA dollar limit will be indexed to the inflation rate in $500 increments. This means that the annual TFSA dollar limit could increase in some years but not every year depending on the inflation rate. However, your unused contribution room in either program may be carried forward to subsequent years. RRSP withdrawals (excluding the Home Buyers’ and the Lifelong Learning Plans) are added to your taxable income and are subject to tax at your marginal tax rate at the time of withdrawal. TFSA withdrawals, on the other hand, are not counted as income and are tax-free. You can take out as much as you like at any time for any reason.2 Unlike an RRSP, your TFSA withdrawal will be added to your contribution room in the following calendar year(s).
- Withdrawals – RRSP withdrawals could reduce amounts you receive from federal income-tested benefits and tax credits such as the OAS, the GIS, and the Canada Child Tax Benefit. TFSA withdrawals do not impact these government benefits.
- Spousal contributions – Attribution rules apply to spousal RRSPs (i.e. total contributions made to your personal and spousal RRSP must not exceed your personal contribution limit), but they do not apply to TFSAs. Although you cannot directly contribute to your spouse’s TFSA as you can with a spousal RSP, you can give your spouse money to contribute to his or her own TFSA without affecting your personal TFSA contribution room.
- Maturity date – An RRSP must be collapsed by December 31st of the year in which you turn 71. A TFSA has no plan maturity.
The answer to whether it may be better for you to contribute to an RRSP or to a TFSA, will depend on a number of factors, including whether you will need to access your money on a short-term basis or your expected tax rate at the time of contribution and at the time of withdrawal (i.e. during retirement). For example, if your income level and corresponding tax rate are unlikely to change between now and retirement, a TFSA may be a sensible choice due to its flexibility and because you won’t lose any tax-savings benefits should you need to access your cash along the way. If you’re in a higher-tax bracket now but expect to be in a lower tax bracket in retirement, it may be a good idea to contribute to an RRSP first as the contributions could produce favourable tax benefits now while deferring taxation on your investments to the future. Any extra savings could then be allocated to a TFSA. If you’re just beginning your career, you may not be earning much at present. However, if you foresee your income rising down the road, you could start off with a TFSA now and then contribute to a RRSP later on when you’re in a higher tax bracket—this strategy would allow you to reap an RRSP tax deduction in the year you make the contribution and would create additional TFSA contribution room (in the following year).