The eternal questions I get every year, especially around tax season, are:
- “Should I max out / invest in my RRSP or TFSA?”
- “RRSP or TFSA, which is the better option?”
- “RRSP or TFSA or both?”
- “Which one should I be concentrating on?”
- “What is the difference, is one better than the other?”
MDJ hears you, and we have put together a catch-all guide answering all of the questions about RRSPs and TFSAs, including what they are, how each works, and calculating the impact of choosing one over the other.
Why RRSPs or TFSAs?
Let’s start with the basics. Why use RRSPs or TFSAs in the first place? Why not a regular saving or investment account?
The simple answer is tax-free compounding. This means your money does not get taxed when growing in an RRSP or TFSA. For example, any money you make on interest from GIC, bonds, or high-interest savings account, as well as on appreciation or dividends on a stock, you pay no capital gains tax. Whereas, if you held them outside of an RRSP and TFSA, all gains (interest, appreciation, or dividends) are taxed.
What does this look like? Let’s take a look below.
*For capital gains, only half of the gains are taxable. For example, if you made $5,000 selling stock, then only $2,500 is taxable. The rest is yours… tax-free.
In the example above, imagine making $40,000, with $5,000 in capital gains (the profit from selling stocks, bonds, property, etc.) and $500 in dividends. On the left, if you made those investments in an RRSP or TFSA account (this applies to TFSA) and kept those proceeds in the RRSP (or TFSA) to reinvest or to your retirement, then you don’t have to pay tax.
On the right side, however, when you have capital gains and dividends, regardless if you use it for reinvestment into your retirement or not, your taxes will go up as the government treats this as income (remember, 50% of capital gains are taxed). Therefore, by investing in an RRSP or TFSA, you can save on paying taxes on capital gains or dividends.
RRSP – What is it?
RRSP (or Registered Retirement Savings Plan) is a retiring savings plan that you, your spouse, or common-law partner can contribute towards. These contributions can be in the form of cash, stocks (equities), bonds, savings (in the form of savings accounts or GICs), or a combination of the above.
Think of it this way – an RRSP is a container that you can put your money in – and this money is in the form of cash or something that can grow due to interest (bonds, savings) or appreciation plus dividend payouts (stocks). This container will protect that cash and investments from government taxation.
Why Contribute to an RRSP?
Simply stated: RRSPs are one of the main ways to reduce the amount of tax you pay in a year by contributing to your retirement fund.
How Does it Work? Benefits of RRSP
Say you live in Canada and earn approximately $50,000 annually at your job. You proceed to save 10% of it (good job!). Let’s see how this plays out when contributing to an RRSP – or saving/investing outside of our RRSP account “container”.
- An average tax rate of 22%, which is more or less an average of the average tax rate across Canada for an income of $50,000. Actual tax rates in each province can vary.
- Tax rate includes Federal and Provincial taxes, CPP deductions, and EI contributions.
- You contributed to your RRSP in the same tax year. E.g. in 2019, you contributed 10% of your net income to your RRSP (or contributed before March 2, 2020, the RRSP contribution deadline to be counted towards your 2019 income).
An estimate of RRSPs vs non-RRSP savings/investing
|4||Contribution / Savings||$5,847.90||$5,847.90|
|7||Estimated Tax Return*||$1,689.00||N/A|
So what is happening in the table above?
Well, in rows 1 to 4, we see that things basically stay the same; you make money (1), pay your taxes (2), have money left over (3), and then save some of it (4). But, from there on, this is where things are different.
By contributing to your RRSP, the government “recalculates” your taxable income. In this case, it treats it like you only made $44,152.10 (5). And because you made less income, you pay less tax (6). Therefore, because there is a difference in how much tax you already paid (2) and what you should have paid (6), you get a tax refund (7) sometime in the spring. (Assuming you file your taxes on time!)
That sounds great, doesn’t it? But there is a caveat to RRSPs: When you retire, and you start drawing funds from your RRSP, there is a tax on what you withdraw. In other words, RRSP withdrawals are considered income (remember, RRSPs are a tax deferral mechanism, NOT a get-out-of-paying-tax mechanism). In fact, banks or financial institutions will hold funds to cover your taxes. For full details – consult Revenue Canada.
TFSA – What is it? Benefits of TFSA
Ok, so now that we’ve covered RRSP, what is a TFSA?
Well, like the RRSP, a TFSA is a container that you can put your money in. Like RRSPs, we TFSAs can store cash, stocks (equities), bonds, savings (in the form of savings accounts or GICs), or any combination of the above. But contributing to a TFSA does not allow you to deduct any tax, like an RRSP.
So then, if you can’t defer your taxes with TFSAs, then why use them?
Simply stated: you pay no taxes on any funds withdrawn from your TFSA. Both the money you put in (your principal – as you have already paid tax on this money) as well as the money you earn from interest or appreciation + dividends.
That’s right. Zero taxes.
Wealthsimple: Growing your TFSA
The easiest way to grow your TFSA nest egg? Spend 2 minutes per year on your TFSA and lock-in the power of diversified growth for your portfolio!
So is TFSA Better Than an RRSP?
At first glance, you might think – “duh… who doesn’t want to pay taxes?”. But things are not so simple. In the next section, we are going to run a few scenarios to see why one might be better than the other, what the main differences are, and what to consider when contributing to RRSPs or TFSAs.
So, what is the main difference between TFSA and RRSP?
Based on what I’ve written so far, you’re probably thinking the following questions:
- “Should I max out my RRSP or TFSA?”
- “Should I max out TFSA and then RRSP? Or vice versa?”
To analyse this, I’m going to pose multiple scenarios using the following parameters:
- We will consider after-tax incomes of $30k, $60k and $90k
- We will assume incomes are steady through your lifetime, but grow at the same rate of inflation (thus removing inflation from the equation)
- Assume you put 10% of your annual income into investments.
- We are going to assume that you begin investing at the age of 30, add to your investments annually at the end of the year, invest until you at 65, and then retire.
- In retirement, assume you will withdraw the following amounts:
- In after-tax income scenarios of $30k and $60k, we will assume you will need to withdraw the same ($30k or $60k respectively) after you retire. We believe this is conservative and should be more than sufficient to maintain your lifestyle.
- In after-tax income scenarios of $90k, we will assume $70k a year in retirement will be sufficient.
- Also, in all scenarios above, we will assume the money is withdrawn at the beginning of the year.
- An 8% annual rate of return (which is slightly lower than the average of the last 20 years of the S&P 500, with dividends included). And therefore, we also will assume all holdings will be index funds.
- There are no other sources of funds, other than income, and your nest egg. Thus, we will not be considering the effects of pensions.
- Most important – all tax returns from contributing to your RRSP are put toward your retirement.
- This is the most significant point we need to stress. If you simply take your tax returns and spend it on a new TV, then you’re better off maximising your TFSAs.
- We will run a bonus analysis to illustrate this point.
Below we will see what happens when you invest 100% in RRSPs or 100% in TFSAs. Keep in mind, all numbers used in this analysis are estimates. See your tax specialist or accountant for more details.
Scenario 1: RRSP vs TFSA – $30K after-tax income
In this scenario, we see that an RRSP nest egg grows almost $600k by year 35 (which at this point we are assuming you’re retiring). For TFSAs – this is about $475k. So far, RRSP wins – your diligence in reinvesting your tax returns back into your nest egg pays dividends and only goes to prove the power of compound interest further.
But when we look post-retirement, we see the RRSP and TFSA continue to grow at the same rate, even though in reality, your RRSP withdrawals will be much more than TFSA withdrawals. Why? Because RRSPs are taxed much like income, whereas the TFSA is entirely tax-free. So, where you can simply take out the $30k you need for that year from your TFSA, you would need to take out roughly $37k from your RRSP.
Overall, we can see and learn some interesting things:
- The gap between RRSP and TFSA begins to separate at about the 15-year mark. This is because reinvesting your tax refunds maximises the power of compounding interest. In other words, while you are putting in only $3k in your investments, when you reinvest your tax refunds, those tax refunds compound overtime.
- If you live to 100, (year 70 on the charts) you will have anywhere from $2 – $2.5 million. Celebrate, because you and your family should be well taken care of.
Scenario 2: RRSP vs TFSA – $60K after-tax income
This scenario is similar to scenario 1 in both trajectory and result.
- RRSPs resulted in a more significant nest egg. Congratulations, your nest egg broke the million-dollar mark, and you retired with a $1.3M nest egg. Your TFSAs are not behind, at $950k at retirement.
- Like scenarios 1, the gap between RRSP and TFSA begins to separate even earlier, at about the 12-year mark. This is because the tax refunds you are reinvesting is larger than in scenario 1, and the power of compound interest magnifies this.
- The divergence between RRSP and TSFA is much more pronounced.
- If you live to 100, (year 70 on the charts) you will have anywhere from $4 – $6 million.
Scenario 3: RRSP vs TFSA – $90K after-tax income
This scenario is unique to scenario 2 and 3 for the following reasons:
- With $90k of income, you will max out the amount you can contribute to TFSAs (the current annual contribution limit is $6000).
- Therefore, for this comparison, we will be considering a 100% RRSP vs a TFSA/RRSP hybrid, where you max out TFSA first then contribute to RRSP.
- Also, to minimise tax paid over your retirement period, in this scenario, we will be withdrawing just under the current amount for the lowest federal tax bracket ($48,000) and then the rest of the funds needed for retirement from TFSA.
- As a reminder, unlike scenarios 1 and 2, we will be taking out only $70k during retirement, as opposed to the equal amount made before retirement. We believe this number to be more realistic and relevant as it is likely things like mortgages and loans have been fully paid off. That said, if you do want to live a more luxurious baller lifestyle, we don’t discourage you, but you may deplete the nest egg much faster (and even cause it to stop growing), so keep that in mind.
Let’s see how this scenario plays out:
Again, we see a similar pattern to scenario 1 and 2 in both trajectory and result, but with a few minor differences.
- The gap between RRSP and TFSA begins to separate later, which is a departure from what we saw scenario 2. In this scenario, both portfolios are almost the same until the 25-year mark. This is the RRSP+TFSA hybrid also takes advantage of some invested tax return.
- The divergence between RRSP and TSFA is less pronounced than in scenario 2. Still, it is interesting how the two portfolios that are very similar but diverge later on in the retirement years.
- If you live to 100, (year 70 on the charts) you will have anywhere from $10 – $14 million. Probably enough for multiple generations of families. Start to think about trust funds at this point.
What happens if you don’t put your tax return towards your nest egg vs TFSA?
As mentioned earlier, one of the mechanisms you need to take advantage in an RRSP is to reinvest those tax returns. Doing so will have an outsized impact when compared to RRSPs that have the tax returns invested as well as TFSAs.
For this simple exercise, we will use the $60k after-tax scenario as our basis:
From the graph, we can see the following implications:
- RRSP, when reinvesting tax returns grew faster. This is again due to the power of compound interest.
- RRSP, when not investing your tax returns grew at the same rate as TFSAs, and well, that is to be expected, as you are putting in the same amount of money.
- Where these two types of nest eggs begin to differ is when you start withdrawing funds. Since RRSPs are taxable and assuming we want an income stream of $60k after taxes, we will need to withdraw just about $80k. This is much more than in comparison to TFSAs, where we simply need to withdraw $60k (remember, tax-free!).
- If you do invest some of your tax returns back into your nest egg some years, then you should expect trajectories between the red and blue lines
Bonus Analysis – The impact of saving more
What happens when you save more than 10% of your annual income? Well, let’s take a look.
For this exercise, we will again be using the $60k after-tax scenario as our basis. To further simplify things, we will only look at the effect of what this does to TFSA funds as it would be safe to say RRSPs will behave similarly.
What we see again is the magical powers of compound interest.
- For every 1% increase in how much of your salary you save, we see a noticeable increase in growth of your nest egg post-retirement.
- At a modest income of $60k, savings more will allow you more flexibility of using more during your retirement. Maybe you want to buy a sunny retirement home or that sports car you always wanted (in cash!). Whatever the case, saving just 1% more can give you vast amounts of flexibility.
This again is another example of the incredible powers of compound interest. Saving an additional 3% of your net incoming is not a monumental task; it merely requires a bit more discipline and planning.
Another way to get ahead of the game is to start early. Every year you start early will have a similar compounding effect on your nest egg. So why not open a trading account with any Canadian discount broker today?
Recap: RRSP or TFSA, which is the better option?
At a high level, it may seem that RRSPs are better – since, in all scenarios above, they result in much bigger nest eggs. A conclusion like that would not be wrong, but it’s also not that straight forward.
Because while RRSPs tend to get larger, the amount you withdraw is always subject to taxation.
That said, we can list some general considerations.
- TFSA is more flexible from a tax perspective. If at any point, you are trying to avoid being taxed or adding to your taxable income withdrawing from you TFSA gives you that flexibility.
- If you know you are going to have a government or other type of pension when you retire, it might make more sense to have a TFSA, as pensions are taxable, and therefore will have a significant impact on the amount your are taxed on your RRSP withdrawals.
- If a significant life event occurs while you are still in the working stages of life, it might make sense to take money out of your TFSA, as this will not impact the taxation of your salary.
- You must be extremely disciplined with RRSPs – you need to put all your tax returns toward your nest egg. Missing even one year, especially early on, will have an outsized impact on your nest egg. For TFSA, you don’t need to work about this.
- When your income after tax is $90k or more, it might make more sense to max out your RRSPs first, then contribute to your TFSAs. This is because tax brackets at this end of the spectrum are quite large, and by maximising your RRSP, you can defer some of those taxes and have compound interest work in your favour. That said, you need to be aware of the impact of pensions (which may make this point moot).
- The returns you get from contributing to an RRSP offer an interesting bit of flexibility when you need additional funds for life or other events.
- Imagine a situation where you receive a tax refund, and you can use it towards something important, say an RESP, additional payment towards or mortgage or simply to cover an expense you simply could not predict. You can use funds from your tax return to cover these things, without selling from your portfolio of stocks, especially when the market is not favourable.
In the end – like almost all things in finance, it’s good to diversify. You can put 50% of your savings into an RRSP, 50% into a TFSA, and receive a little of each benefit.
All in all, the most important thing to take away is this – start saving and investing now. It is quite simple, and you can even begin today by opening up RRSP and TFSA accounts at Qtrade for example.
Can I transfer TFSAs to RRSPs?
The short answer is no – there is no technical mechanism to transfer TFSAs into RRSPs (or vice versa).
That said, you can sell what is in your TFSAs (say sell $1000 worth of investments) and contribute this to your RRSPs, but for the most part, this won’t make a lot of sense. Overall, you are better off either contributing to your RRSPs directly by some other means (RRSP top-up loans) or saving that contribution room and using it next year.
You might be asking, “Why would selling my investments in TFSAs not be worth putting towards my RRSPs? Won’t I get a good tax refund that I can then put into my RRSP?”.
Well, it depends on many factors, including whether it’s a good/bad time to sell said investments, and what type of fees you will incur (which eats away at your investment). There is also the tax implications that result from taking funds out. In other words, funds might be taxed at a higher marginal rate since the tax rate will consider both these funds and other sources of income (like your salary if you are currently working)”.
Simply said, selling your investments in your TFSA depends a lot on whether selling those said investments is the right time, incurring fees (which eats away at your investment) and also the tax implications that result from taking funds out at a higher marginal rate.
If this all sounds complicated, it’s because it is. But because it is, it means you should be prudent and try to avoid any situations that might negatively impact you in the grand scheme of things.
If enough people write in about expanding on this, I will write a short article on it.
Can I transfer RRSP to TFSA without a penalty?
Like with TFSAs to RRSP, the answer is unfortunately no. Being able to transfer from RRSP to TFSA would be extremely valuable since not only did you defer taxes and benefit from it, you were able to make your nest egg non-taxable when you withdraw. That would be like double-dipping (or triple dipping?).
In any case, there is no way to do this without selling your investments in your RRSP, incurring taxes, and then moving said funds to your TFSA.
Note for those technically advanced; I will not be covering setting up a Mortgage Investment Corporation (MIC) and using the complex CRA rules to set up RRIFs, borrow and then pay back your TFSA, technically making it “tax-free”. The reason being it is a bit complex; you need to have substantial assets ($1M) or a significant amount of personal/family income. If you are interested, you might want to reach out to a wealth manager who can walk you through the steps and execute on your behalf.
What if I withdraw less from my RRSPs?
I already anticipate comments from folks about RRSPs not lasting as long as the TFSAs. But remember, in the scenarios above, we assume that you will be taking out the same amount of money in retirement as you made during your working years.
If you take out less, you naturally increase how long your nest egg lasts. In fact, if you can limit your withdrawals to 4% of your portfolio annually, then your nest egg should technically last indefinitely. To find out why, download our free e-book. But keep in mind, this also holds for TFSAs.
TFSA vs RRSP vs RESP
By now, you should know the difference between TFSA and RRSP (TFSA = no tax when you, RRSP = tax deferral mechanism). So what is an RESP?
RESP stands for Registered Education Savings Plan. These are special accounts, like RRSP, that allow you to save for your child’s education (typically post-secondary) by contributing to a fund, much like you do for an RRSP and TFSA. Like an RRSP or TFSA, you can contribute in the form of cash, stocks (equities), bonds, savings (in the form of savings accounts or GICs), or a combination of the above.
Now, unlike RRSPs, there is no tax benefit to contributing to an RESP (you don’t receive tax credits). But when your child withdraws from the account, it is practically tax-free (your child likely is making less than the base individual amount since they are going to school) – so it’s more similar to a TFSA.
TFSA or RRSP for a down payment?
Can it be done? Of course. At any time, you can take money out of your TFSAs and use it toward a purchase, such as a down payment for a house.
That said, which is better? This question is a bit complex. In some ways, it depends. In other ways, it makes more sense to take money out of your RRSPs. In our opinion, it makes sense to take money out of RRSPs. Here is why at a high level:
- Remember, RRSPs allow you to defer your taxes – while using an RRSP for a down payment can be tax-free when down through the Home Buyers’ Plan (HBP).
- Under HBP, you can take out up to $35k (as of 2019) to pay towards a downpayment.
- You need to pay this back every year, for fifteen years. The amount you pay back is approximately 1/15ths of what you withdraw.
- Also, there is an added benefit of an HBP tax credit (though it’s only about $750 in tax savings, but that’s better than nothing right?)
- Remember the scenarios above? TFSAs are better kept untouched and growing since they will return the best and highest nest eggs possible.
- Furthermore, TFSAs are tax-free and flexible. It is much more prudent to use your TFSA account to tackle the unknown and unfortunate events in your life since you can take money out of this account without any worry about tax implications.
TFSA or RRSP with Pension
The most significant consideration here is likely impact on taxable income, but there are other considerations that you need to account for.
First off, contributing to your TFSAs should not affect you or your company pension, nor will it affect your eligibility for government benefits like OAS. RRSPs, on the other hand, will have to coordinate with pensions as they count towards your contribution limit/room. For more information, see here.
For post-retirement with pensions, you might be better off with a TFSAs during retirement. Why? Because any pension you receive (e.g. teachers pension) is taxable income. And if you are withdrawing from an RRSP nest egg, then this can be a double whammy.
To illustrate my point, let’s look at two scenarios:
- $30k from pension and $30k from TFSA
- $30k from pension and $30k from RRSP
In scenario 1 – your taxable income is only $30k, and at the end of the day, your average tax rate will be approximately 17%, and you will receive $54,909.
In scenario 2 – both incomes are taxable and will significantly raise your average tax rate to about 23%. In the end, you will only receive $45,844, a difference of $9,065.
Simply being aware and investing in the right type of portfolio can have a significant impact on the tax you pay and your annual retirement amount.
Other minor considerations:
- Most company pension plans have liquidity risk (you are usually locked in until you retire or change jobs). Also, most company pension plans will have limited investment options (never a good thing, since most mutual funds underperform the market).
- Keep in mind that if you do have a private company pension, the amount you can contribute to your RRSP will be less than the 18% that you are typically allowed.
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