While RRSPs have been around longer than TFSAs, their use and structure have frequently been misunderstood. Now that we also have TFSAs there seems to be even more confusion regarding which accounts to use for your long-term savings. RRSPs and TFSAs both have tax-saving benefits, but differ greatly in how and when tax is saved. There are various factors which could affect the suitability of each account for your own personal situation. Read on to learn more about each account type, and figure out which one may be right for you.
RRSPs are tax deferred
An RRSP offers Canadians a way to save for retirement, while postponing taxable income to a later date. The way this works is, any contributions you make to your RRSP within any given year, will be applied against your taxable income on your tax return for that same year. Later on when you withdraw from your RRSP, you then add that money to your taxable income for that same year (as in the year you withdraw). I should note that you are also allowed to contribute to your RRSP up until March 1st for the previous year.
For example, this year is 2021. If I wanted to contribute to my RRSP to reduce my taxable income for the 2021 tax year, I can make contributions up until March 1st 2022 and still count them towards my 2021 tax return.
Why reduce taxable income?
Doesn’t it hurt at least a little bit when you check your pay stub on payday and see how much of it goes to taxes? Reducing your taxable income is a way to get some of that ‘lost’ income back in your bank account. Allow me to explain:
Our tax system is set up to tax higher income earners more tax than lower income earners. In a nutshell the more money you make, the higher the rate of tax you pay. Therefore, the less money you make, the lower the rate of tax you have to pay.
Reducing taxable income makes it seem like you make less money than you do, ultimately causing you to pay less tax. Sounds like a pretty good deal right?
Unfortunately, we still do have to pay tax on this money eventually. Luckily for us, we do have some say over when that time is. As I mentioned above, when you withdraw from your RRSP you then have to count that withdrawal as taxable income for that year. You are basically transferring taxable income from one year to another.
All of this income reduction and tax deferral may sound like a lot of effort for not a lot of reward, but think about your own situation as I walk you through the following example:
Note: I am using fictitious tax brackets in this example to keep the math simpler.
Let’s say back when I was younger I was making $20,000 a year. At this income level I would be in the bottom tax bracket paying roughly 20% in income taxes, or for a hard number, $4,000.
Being the personal finance geek that I am, I follow the sometimes unrealistic rule of thumb of putting away at least 10% of your gross income for long term savings. This means I would be contributing $2,000 a year of my $20,000 annual income into my RRSP. This contribution would reduce my taxable income by $2000 causing me to only owe 20% taxes on $18,000, or $3,600. The net result would give me a tax refund each year of $400 (the difference between the original $4,000 tax bill vs $3,600). Not only am I saving for retirement but I am also saving money now.
Now that I am a little older I could be making about $50,000 a year, bumping me into the next tax bracket paying about 25% in income taxes, or $12,500. I fall victim to income inflation, buy a new vehicle and go out for dinner a lot more with my big raise, so I can only afford to put that original $2,000 a year as I did when I made less money. Now that $2,000 reduces my taxable income to $48,000, and I only owe $12,000 in taxes for that year, giving me a savings of $500 annually. I still get to set aside that same $2,000 a year for retirement, but now I am saving an extra $100 a year in taxes as well.
Years go by, I work hard and get a couple more raises, and now am in my prime earning years, making $100,000 annually. The tax bracket I’m now in hits me with a 30% tax rate, making me cough up $30,000 annually. I realize that I can get away with continuing to contribute just $2,000 a year to meet my retirement goals, and reduce my taxable income to $98,000 a year, lowering my tax bill to $29,400. I’m now saving $600 each year on taxes, up from $400 from when I first started contributing.
One day, I will finally get to retire. Through careful financial planning, I conclude I need an income of $40,000 a year to enjoy my retirement. The government is kind enough to give me half of that, leaving me to use my RRSP to fund the rest. I want to enjoy my retirement, so I withdraw $20,000 each year to make up the difference from government pensions for a total annual income of $40,000. After all those years my $40,000 makes the cut for the bottom tax bracket, and the tax rate happens to stay the same at 20%, causing me to owe $8000 in income tax.
As you can see, the RRSP is built to postpone taxes, not eliminate them. You may have also noticed that tax savings increase as income increases. This makes them more advantageous for higher income earners, or for people who suspect they will have a lower income in retirement than they have now.
Obviously this is a very simple illustration of RRSP contributions, and your personal situation can vary greatly, but the concept is the same. The more money you make, the more money you owe. The more money you contribute, the more money you get back from the money you owe, all while socking money away for when you get to enjoy not worrying about this anymore.
One thing I did not cover in this example is the fact that your investments can grow tax-free inside the RRSP account, and are only taxed when you make a withdrawal. This is definitely worth considering as investment income is typically taxed at your marginal tax rate (tax bracket you fall into based on annual income) in the year it is realized, unless it is inside a registered account. For example:
If I was investing my $2,000 into a GIC that paid 2% interest, I would earn $40. I would be expected to pay tax on that $40 depending on which tax bracket I was in. Going back to my other example, if I was earning $100,000 and had to pay 30% in taxes, I would owe $12 on that $40 if it wasn’t inside my RRSP, cutting my return by almost a third! While had I invested in the same GIC inside my RRSP, I would keep the entire $40 and it could then go on to compound with next year’s contribution and so on and so on. Only when I decide to withdraw any funds from the RRSP do I then pay any tax on the earnings.
Hopefully you can start to see the advantage to using an RRSP for your retirement savings. There are of course some rules to be aware of before doing so. Mainly, there is a limit to the amount you are allowed to contribute every year, which is based on previous years income and cumulates until used up. Your RRSP contribution limit is always printed on your notice of assessment you receive after filing your tax return every year so you do not need to calculate it yourself.
A word of warning regarding contribution room with RRSPs: While you can withdraw from your RRSP and pay tax on that money whenever you wish, you will NOT get that contribution room back. It will be gone forever, and therefore it is not recommended you make any withdrawals until you are in retirement.
The other big thing to be aware of is that RRSPs have an age limit on when you can contribute until, and after that age, you will be required to start withdrawing from the RRSP. I will go into the forms of withdrawal in another blog post, but for now just know that you can’t keep letting your investments grow and never withdraw from the account. The current age limit for this forced withdrawal is 71.
One final thing I would like to mention about RRSPs is that there is an added benefit when holding US investments in them. Due to a tax treaty between Canada and the US, you do not pay any withholding tax on dividend income from US investments, as long as the investments are held within your RRSP. Withholding tax is essentially other countries’ share of the tax due on your income and a topic for another blog post.
- Save on taxes now to pay them later in life
- Investments grow tax free until withdrawal
- US withholding tax treaty
- Potential employer contribution
- Forced Withdrawal
- More complicated tax planning
- Strict contribution room
TFSAs are tax eliminating
TFSAs are relatively new in Canada, and while their structure and rules may seem a bit simpler, there is still some misunderstanding surrounding them.
Like the RRSP, they are intended as a long-term savings vehicle. Also, just like the RRSP, they let your investments grow tax-free inside the account, allowing any income earned to compound on itself without the effect of taxes cutting into returns.
The major difference between RRSPs and TFSAs is that while RRSPs let your income grow tax-free, postponing taxes until you withdraw, the TFSA will also let your income grow tax-free, except that you will not owe any taxes on your withdrawal. This may or may not sound like a big deal, but once we walk through an example you will see how substantial tax-free growth can be.
Now, as with the RRSP, there are some rules to be aware of. The major one is that contributions made to a TFSA are made with after-tax dollars, therefore, you will not be reducing your taxable income, and will not be receiving tax refunds for those contributions.
The contribution room also works a little bit differently in that whenever you make a withdrawal, you gain that contribution room back in the following calendar year. The amount you are allowed to contribute is a set amount each year that will periodically increase to keep pace with inflation.
Why eliminate taxes?
I am going to revisit my previous example with a couple of changes to illustrate when a TFSA may be more beneficial. As with before, I diligently put $2000 a year away for retirement, just this time into a TFSA rather than an RRSP. I will not be getting any tax refunds on this money so the tax bracket I fall into is irrelevant at this time. Again my income grows and for various reasons I continue to just contribute the original $2000 a year.
This time I decided to invest in a balanced mutual fund offered by my bank’s financial advisor. My net return after fees averaged 4% annually and I invested for 45 years, leading to a final portfolio value of about $242,000. Now, this investment could have been made in a TFSA or an RRSP and ended up at the same value. However, I am about to show you the magic of the TFSA and you will notice the difference in the after tax result.
As with the previous example, I still only need $40,000 gross annually to fund my retirement, and the government is going to give me half of that, or $20,000. In the RRSP scenario I needed to withdraw $20,000 from the account, which is fully taxable, causing me to owe $8,000 in taxes. This would leave me with $32,000 in my pocket for the year.
Now, with the TFSA, any withdrawals do not count towards your taxable income. This means that only the $20,000 the government gives me is taxable, giving me a tax bill of only $4,000, or leaving me with $16,000 net. To make up the difference I would only need to withdraw $16,000 from my account rather than $20,000, essentially saving me an extra $4,000 that could have been going to taxes every year!
As you can see, the TFSA can offer some serious tax savings, but how does it compare with the RRSP?
Let’s assume the RRSP example made the same investment over the same time horizon. Let’s also assume, just to ignore any averaging bias, that we actually had the largest refund from the example for the entire investment period, which was $600 a year. In this case the tax savings from the contribution period for the RRSP would be $27,000. $242,000 would last just over 12 years with a $20,000 annual withdrawal, and assuming we took the same out of each account, the TFSA would then give us a tax savings of $4,000 each year or $48,000 over the course of the withdrawal period. Even before netting out the taxes paid vs saved of the RRSP, you can see the TFSA would have saved more overall tax.
- Simpler tax planning
- Greater tax saving potential
- Regain-able contribution room
- Freedom to withdraw when you choose
- Confusing name
- No immediate tax savings
Which to choose?
It is important to note that the TFSA is the winner in this example only. The time horizon for the investment period was very long and the strategy had slightly higher returns than one more risk-averse. It is also worth considering what is being done with the tax refund each year it is earned. That extra $600 could be re-invested elsewhere or used to pay down high interest debt leading to other compounding returns not illustrated in the example.
Ideally, everyone would max out each of these accounts at some point in their lives before heading into retirement but that is just not the case in today’s world. Generally for those just starting to invest I will often recommend a TFSA to younger people who may not be earning as much as they would be later in life, or for people who would expect higher returns on their investments. If someone is earning a higher income and could benefit from immediate tax savings, or their investment portfolio is a little more complicated, I might suggest they opt for the RRSP. There are some other behavioural elements that should be considered as well, but the main point is to get started and stay invested.
As you can see the choice between an RRSP or TFSA isn’t just black and white, but for those just getting started with investing should have the information they need to make a decision. And if not, reach out! I’d love to help you figure out which account is best for your personal or family situation.
Have anything to add to this post? Or did it leave you with more questions than answers? Please comment below and so I can answer your questions or go over it in detail in another blog post!