The Tax Free Savings Account (TFSA) introduced in 2009 has been considered the best tax break since the introduction of the Registered Retirement Savings Plan (RRSP) back in 1957. The TFSA allows you to save for your future without paying taxes on any interest earned. I’m constantly asked if the TFSA is better than the RRSP, and which savings vehicle is the right option. The answer? It depends on individual needs.
Before we can answer this question it’s best to understand the similarities and the differences of the two plans, and decide which is best for you.
The RRSP is a savings vehicle for your retirement. When you make an RRSP contribution, you can deduct that amount from your taxable income as long as it falls within your contribution room. If you do not use your RRSP room, it doesn’t disappear. You can make up contributions at any time. You can contribute to an RRSP from the age of 18 and can continue to contribute up to the age of 71 as long as you have earned income, which will build your RRSP room. You can also contribute beyond the age of 71 to a RRSP for a younger spouse, as long as you still have RRSP room. For those that have a pension plan, your ability to contribute to an RRSP is limited and your contribution room is reduced by the pension adjustment or value of your pension benefits earned.
The investments inside your RRSP grow free of tax while the funds remain in the plan. Eventually, when money is withdrawn either directly from the RRSP — or from the registered retirement income fund (RRIF) or annuity to which the RRSP has been converted — it will become taxable.
The RRSP also has two special options which allow you to withdraw RRSP funds without tax consequences — the Home Buyers’ Plan (HBP) and the Lifelong Learning Plan (LLP). Under the HBP, those who are considered first time home buyers can withdraw funds tax free to buy or build a qualifying home. The funds withdrawn must be paid back to the RRSP over a 15-year period. Under the LLP, qualifying students can withdraw funds tax free to fund qualifying educational programs. Withdrawn funds must be repaid to the RRSP within 10 years.
Unlike an RRSP, TFSA contributions do not reduce taxable income. However, the big benefit of the TFSA is that, once the money is in the plan, investment income (interest, capital gains and dividends) not only grows free of tax but also can be withdrawn free of tax. Like an RRSP, you can name a beneficiary, and the rules to roll over to a spouse at death are the same for both plans.
The TFSA has specific contribution limits. As of 2018, the lifetime total amount you could contribute is $57,500. You can start contributing at the age of 18, and if you miss a contribution it is not lost. Also, you can withdraw from a TFSA without tax consequences at any time, and later replace the amount withdrawn in addition to the annual new amount. However, don’t replace the funds withdrawn until the following tax year, due to stiff penalties on over contributions of 1% per month. This penalty also applies to RRSP over contributions.
Both the RRSP and TFSA are similar plans allowing for a lot of flexibility in how you save for your future. The vehicle which is right for you depends mostly on your stage of life. A TFSA may be the best choice for young taxpayers, because their income during retirement will likely be higher than their current income. During peak earning years, contributing to the RRSP makes more sense due to the tax deduction, and the likelihood that your tax rate will be lower when funds are withdrawn from the RRSP. In retirement, the focus is usually on drawing out the RRSPs or RRIFs and, if funds are not required for living expenses, then the ideal choice is to use the annual RRSP/RRIF withdrawal to contribute to the TFSA to continue to save tax free for your personal goals.
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