Investing: TFSA vs. RRSP

Since the introduction of the Tax-Free Savings Account (TFSA) over a decade ago, comparing the TFSA with the Registered Retirement Savings Plan (RRSP) has become a common source of discussion in Canadian personal finance. The TFSA vs. RRSP debate is one of the most common comparisons of Canadian financial products. This is especially true when it comes to using the accounts for the purposes of investing.

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Although these two accounts are similar in a few ways, each one has enough nuances (primarily concerning taxes) to make each account unique. Below, we'll take a look at TFSAs and RRSPs from the perspective of investing, while touching on some benefits of using each account for saving.

Although these two accounts are similar in a few ways, each one has enough nuances (primarily concerning taxes) to make each account unique. Below, we'll take a look at TFSAs and RRSPs from the perspective of investing, while touching on some benefits of using each account for saving. 

Investing with a Tax-Free Savings Account (TFSA)

The Tax-Free Savings Account (TFSA) is a tax-sheltered account for investments and savings. Like an RRSP, you can hold a wide range of investments in your TFSA, including mutual funds, stocks, bonds, GICs, and ETFs, to name a few.

The amount you’re allowed to contribute to your TFSA isn’t dependent on the amount of income you earn. You don’t need to earn any income at all to get a contribution room for your TFSA. The CRA sets annual contribution limits. Every Canadian starts accumulating a contribution room once they turn 18. The money you put in your TFSA doesn’t reduce your taxable income, but any earnings generated by the investments inside your TFSA aren’t taxed. 

If you make $100,000 in a year and you contribute $10,000 to your TFSA, your taxable income will still be $100,000. But any interest, capital gains, or dividends earned by the $10,000 in your TFSA grow tax-free, and you can withdraw these funds at any time.

The annual TFSA contribution limit for 2019 is $6,500, making the total contribution room $63,500. As with RRSPs, if you don’t contribute the full amount to your TFSA in a given year, your unused contribution room carries forward.

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Investing with a Registered Retirement Savings Plan (RRSP)

The Registered Retirement Savings Plan (RRSP) is a tax-deferred and tax-sheltered account used for retirement savings.

There are many RRSP investing options options available in Canada. Like a TFSA, you can hold various types of investments inside your RRSP, including mutual funds, stocks, bonds, GICs, ETFs, and regular savings.

Whatever money you contribute to your RRSP reduces your taxable income. For example, if you make $100,000 in a given year, you contribute $10,000 to your RRSP, and you claim the entire deduction, your taxable income effectively becomes $90,000. Any interest, capital gains, or dividends earned by the $10,000 in your RRSP grow tax-free.

However, you pay taxes when you withdraw money from your RRSP because your withdrawal counts as income in the year that you take cash out. There are a couple of exceptions to this rule. 

If you participate in the RRSP Home Buyers’ Plan or the RRSP Lifelong Learning Plan , you can make a tax-free withdrawal from your RRSP. Just bear in mind you'll have to re-contribute your withdrawal.

The amount that you can contribute to your RRSP depends on how much money you’ve made in the previous year. Your RRSP contribution limit is 18% of your earned income from the last year, up to a maximum amount determined by the CRA. 

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Investing in your TFSA and RRSP together

By now, you should have a sense of how the TFSA vs. RRSP comparison really has the same benefits on both sides. Using both is a very suitable option, regardless of what your goals are.

TFSAs are extremely flexible because you can use them for virtually any type of investing goal. You can use it as an emergency fund, to save for a down payment on a home, a new car, a vacation, or even save for retirement. It’s recommended that you use your TFSA instead of your RRSP when you’re in low tax brackets and you earn a small amount of income because TFSAs have no upfront tax benefits.

RRSPs on the other hand, are used almost exclusively for saving for retirement. You can also make tax-free withdrawals to help fund your first home purchase or to advance your education. RRSPs are most effective if you contribute while you’re in high-paying tax bracket, as contributions will help put you into a lower bracket. After you’ve retired, withdrawals from your RRSP will be a source of income, but you’ll be in a lower tax bracket compared to when you were working.

Many Canadians don't recognize how versatile TFSAs and RRSPs are, often underestimating what investments each account can individually hold.

Investments are a pivotal feature of the capabilities of each account. Some investments that can be held in a TFSA or an RRSP include:

Mutual Funds

A Mutual Fund is a portfolio containing different securities, such as bonds and stocks.  Mutual Funds held in a TFSA Mutual Fund or an RRSP Mutual Fund can grow significantly without taxation on dividends. Note that withdrawing from a RRSP Mutual Fund is subject to tax upon withdrawal. TFSA Mutual funds, on the other hand, are not. Generally, major banks offer and manage mutual funds on behalf of all clients involved for a small fee.

Guaranteed Investment Certificates (GICs)

Guaranteed Investment Certificates (GICs) are term deposits that earn interest.  The rate of interest is guaranteed and confirmed with the investor before investing. Funds are locked into the account once the investment until it reaches maturity. Generally, GIC terms range from 30 days up to five years in length.  Interest earned in a GIC is taxable—unless invested in a TFSA GIC or an RRSP GIC.

Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) operate similarly to mutual funds, which also manages and trades various securities. However, unlike mutual funds, ETFs are owned by an individual investor.  This allows the investor to adjust their investments according to their personal preferences. 

ETFs can also harvest tax-free gains when placed in an RRSP or TFSA.

Stocks

A stock is a piece of a company or a corporation owned by an investor. That's why they're also known as shares. Stocks generally have a higher risk ratio. That said, they've historically performed the best out of any investment. Placing stocks in a TFSA or RRSP is an excellent way to make the most of your capital gains. 

Bonds

Bonds, similar to GICs, operate a lot like loans. However, in the case of bonds, a corporation or government issues the bond to the investor, providing them with interest in return.  Of course, as long as the contributions and the interest remain below the yearly contribution limit, bonds placed in a TFSA or RRSP grow tax-free.

Savings

Both the TFSA and the RRSP function primarily as savings accounts, though each account can hold various investments. As savings accounts, however, the TFSA and the RRSP can help your interest on your savings grow untaxed.  In terms of saving, both accounts hold cash. That means your money.  TFSAs allow interest on your money to grow tax-free, with unlimited deposits and withdrawals.  RRSPs allow your money to grow tax-free—until withdrawal. The amount you contribute each year reduces the annual income tax you're required to pay.