With the introduction of the Tax Free Savings Account (TFSA) in 2009, Canadians have been able to invest their hard earned money in two types of registered investment plans. That’s great news for anyone seeking the benefit of tax-sheltered growth for their savings, but it has also been the cause of some confusion, as many people wonder if one type of account (TFSA or RRSP) is better for them.
In this article, I’ll cover some of the similarities, as well as the main differences between the two. I’ll explain why it’s impossible to choose one over the other in all situations, and let you know where you can open a TFSA or RRSP online, and start investing today.
The TFSA – What’s in a Name?
It could be said that the Tax Free Savings Account suffers from a branding problem. Because of those last two words, ‘savings account’, many Canadians have had difficulty grasping the TFSAs investment potential. As such, across Canada, billions of dollars are being held in cash, inside TFSAs, at any given time. There are not much tax savings to be had when you’re only earning 1% interest.
On the other hand, growth investors can benefit from enormous tax savings over the long term, by holding any number of equity investments inside their TFSA. Stocks, bonds, ETFs, mutual funds, all of these can be purchased inside a TFSA account. Before we compare TFSAs and RRSPs, here’s a look at some of their key features.
Basic Features of a TFSA
- Flexible investment option for both short term and long term savings goals
- Tax-sheltered account
- Annual contribution limit of $6,000 (as of 2019)
- Lifetime contribution room of $63,500 (for Canadians 18 years and older during all qualifying years)
- Contributions are NOT tax deductible
- Funds can be withdrawn at any time without penalty
- Any RRSP eligible investment can be held in a TFSA, such as stocks, bonds, mutual funds, ETFs, GICs, cash etc.
- 1% monthly penalty for overcontributions
Basic Features of an RRSP
- Ideal for retirement savings
- Tax-sheltered account
- Contributions are tax-deductible
- Annual contribution limit is equal to 18% of earned income, up to a maximum of $26,500 (2019)
- Unused contribution room is carried forward to subsequent years
- There is a penalty for RRSP withdrawals
- Funds can be borrowed from an RRSP (without penalty) under the Home Buyers Plan (HBP), and the Lifelong Learning Plan (LLP)
- RRSP must be converted to a RIF by December 31st of the year in which you turn 71
Main Differences Between TFSA and RRSP
While both the TFSA and RRSP provide investors with tax-sheltered growth, there are some key differences you should be aware of.
- Funds invested in a TFSA can be designated for any number of savings goals, both short term and long term. An RRSP, on the other hand, is meant for retirement savings.
- You must have earned employment income to contribute to an RRSP, and your income level determines your contribution limit. Contributions to a TFSA are not tied to income.
- The annual contribution limit for a TFSA is lower than that of an RRSP: $6,000 vs. $26,500
- Contributions to an RRSP are tax deductible. That’s not the case with a TFSA.
- You’ll pay income tax on funds that you withdraw from an RRSP, while TFSA withdrawals are not subject to tax. This is a result of the tax deductibility of RRSPs
- Money in an RRSP can be held until the last day of the year in which you turn 71, at which point, for most Canadians, the account would be converted into a Registered Income Fund (RIF). A RIF is designed to pay out income to the account holder for the remainder of their lifetime, and cannot receive contributions. There is no age limit at which you need to close a TFSA account.
- RRSP withdrawals are income tested, meaning they are added to your taxable income, whereas income pulled from a TFSA is not. This can have implications in retirement, as OAS benefits begin to get clawed back when your taxable income exceeds $77,580 (2019).
- There is a difference in the way RRSPs and TFSAs are treated upon the death of the account holder. With an RRSP, you can name a beneficiary, where with the TFSA you have the choice of naming a beneficiary, or you can designate your spouse as a successor holder.
TFSAs & RRSPs: Working Together for Your Retirement
On their own, TFSAs and RRSPs have their limitations. That said, it’s possible to create a very effective retirement income strategy by harnessing the power of both accounts. This is especially true for higher income earners. As I mentioned earlier, funds withdrawn from an RRSP are considered taxable income. The more you withdraw, the higher your income will be. Canadians 65 years old and over are eligible to receive the Old Age Security Benefit (OAS). But that benefit starts to get clawed back as soon as your income exceeds $77,580 (2019).
Instead of relying on income from your RRSP, stop withdrawing before reaching the OAS clawback, then switch to a well-funded TFSA to pull any additional income. Unlike RRSPs, TFSA withdrawals aren’t considered taxable income, so they won’t create an OAS clawback. Even when there’s no danger of receiving an OAS clawback, it may still be a good idea to halt RRSP withdrawals before reaching a higher marginal tax bracket, and instead withdraw from your TFSA. Over time, this can result in significant tax savings.
RRSP Home Buyers Plan & Lifelong Learning Plan
There are two instances in which you can borrow money from your RRSP and avoid penalties. The first is the Home Buyers Plan, a federal government program which allows first time home buyers to borrow money from their RRSP for the down payment on a home. They then have up to 15 years to repay the amount back into their RRSP.
The Lifelong Learning Plan allows students to borrow funds from their RRSP to put towards their postsecondary education. You have up to 10 years to repay LLP funds. These two programs add flexibility to RRSPs, making it easier to plan for these major expenses when they arise. After all, you don’t always know when the time will be right to buy your first home or go to school.
Is an RRSP Worth It?
The flexibility of a TFSA is a really attractive feature. In fact, many younger Canadians seem to favour the TFSA for this reason. Statistics Canada reporting shows that the households more likely to contribute to TFSAs were those in which the primary income earner was under 35 years old.
Even though I’ve made a pretty strong case for RRSP investing, you may be wondering if an RRSP is still worth it. Especially if you don’t have enough money to make the maximum contributions to both plans. The answer is, absolutely. Because aside from the benefit of tax deductibility, the RRSP remains the more effective vehicle for retirement savings. This leads me to the one caution I have about the TFSA.
The TFSA: Effective for Retirement Savings?
The flexibility offered by a TFSA may actually make it less effective as a retirement tool. Here’s why. With an RRSP, you pay a significant penalty anytime you withdraw, with the exception of withdrawals made under the HBP and LLP. This acts as a disincentive for anyone who’s thinking about withdrawing funds before they retire.
If you’re using a TFSA as your sole source of retirement savings, without the penalty, it’s easier to justify making withdrawals along the way, say for a vacation, or a major purchase. The problem is that by removing funds prematurely, that money is no longer invested, and working for you. Over the long run, this can create a massive gap in your retirement nest egg.
Where to Invest Your TFSA or RRSP
If you haven’t yet taken the step of opening a TFSA or RRSP account, you may be wondering where to start. Many Canadians hold these accounts with their primary banking institution, be it a bank or credit union. In other words, the same place where they have their chequing account or their mortgage. And that’s a viable option. All Canadian banks ie. RBC, Scotiabank, have a full selection of investment products for your TFSA or RRSP, and many credit unions have similar options.
These days, however, many people prefer the convenience of online investing. Thankfully, there are a number of ways to invest in a TFSA or RRSP, without having to step foot in a bank branch. If you’re a more experienced investor, you might prefer using an online discount brokerage to invest your TFSA or RRSP. Another option is to use a robo-advisor. Let’s take a look at how each of these work.
Investing Through an Online Brokerage
Online brokers, also known as discount brokerages, offer a complete do-it-yourself investing experience. The main advantage of using an online brokerage is having near unlimited investment options, at your fingertips. You can hold individual stocks, bonds, mutual funds, ETFs, even GICs, in an online brokerage account. Because you’re the one executing the trades online, you’ll avoid the high fees charged by an investment advisor.
Canadians have a large number of discount brokerages to choose from. All of the major banks have their own discount brokerage, and offerings from RBC and TD are amongst the best in the business. Here at MapleMoney, our top choice is Questrade, an independent online brokerage offering the best platform for ETF investors, at the lowest prices.
Unlike some of the bank offerings, which require you to visit a branch to complete the account opening process, with Questrade you can open an account online, and start investing right away. You can use my exclusive link below to open your Questrade account or read my full Questrade review to get more information. You can also check out my in-depth comparison of Canada’s leading discount brokers.
Investing with a Robo-Advisor
Robo-advisors have been around for a few years now, and have become very popular. When you deal with a robo-advisor, you can be rest assured there are no robots involved. Instead, the term refers to a company that uses online technology to develop a portfolio that reflects your risk tolerance and then automates your investment contributions.
While it is sometimes possible to speak with a portfolio manager, the idea is to invest without the involvement of a human advisor. The benefit to the investor comes in the form of lower fees, and the ease of investing from the comfort of your living room.
Most robo-advisor portfolios use exchange-traded funds (ETFs), which in many ways resemble mutual funds, but trade like a stock on the exchange.
There are a number of companies offering robo-advisor services in Canada, but at the moment our top choice is Wealthsimple. Through Wealthsimple, you can open an RRSP or TFSA online, and begin investing today. If you use my exclusive link, they’ll even manage your first $10,000 free of charge!
TFSA vs. RRSP – Dare to Compare
A comparison between the TFSA and RRSP is not a matter of one being better than the other. The simple answer is that you need both in your portfolio. Regardless of your age, or your income, there will be times when contributing to your TFSA makes more sense and others when your RRSP is the way to go.
For example, a general rule of thumb for high-income earners would be to always maximize RRSP contributions before contributing to a TFSA, to benefit from the tax deduction. But your income could drop in any given year. In that case, the RRSP contribution loses value, and the TFSA becomes more attractive.
Here’s another consideration. Most people are saving for other things besides retirement. A new car, a home renovation, or that dream vacation you’ve been planning. Here, the TFSA is the more flexible choice, because you won’t be penalized when you withdraw funds. So, you can see why it’s impossible to choose one over the other in all situations. Your best bet is to contribute to both. As always, seek professional advice to make sure you’re following the plan that’s right for you.