Personal Tax

TFSA vs RRSP - How They Work and Choosing Between Them

Paul Sharpe, CPA, CA
December 12, 2022

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Uncover the differences between TFSAs and RRSPs to know when it's best to choose one account over another.

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RRSP vs TFSA - Which is Best?

We talk a lot on this blog about running a business and using that business to generate wealth.

I truly believe that owning and operating a business is the best way to create wealth, and it's the primary way that I invest my time and money.

However, running a business isn’t for everyone, and there are other great ways to save money, invest and generate wealth here in Canada.

In this article we'll look at two very common, but also very powerful, investing accounts available to Canadians. 

We’ll look at the Tax Free Savings account, or TFSA, and the Registered Retirement Savings Plan or RRSP.

I’ll explain how each type of account works, the pros and cons for each account type, and when to use one account over the other.

Or, check out the video below 👇 if you'd rather hear Joe explain it!

RRSP and TFSA General Overview

Let’s start with a general overview of what the heck RRSPs and TFSAs are before we get into the details.

RRSPs and TFSAs are investing accounts that are made available by the Canadian federal government.

I like to think of each account as a big bucket that you can dump your cash into.  

The cash can then be invested in various different types of investments, but it’s all done inside of the bucket.

For example, let’s say I took $1,000 and dumped it into my RRSP bucket.

The RRSP bucket now has $1k of cash sitting in it. I could then use that cash to purchase investments of various types.

Let’s say I purchased $1,000 worth of shares in a publicly traded company like Shopify. The investment is still within the RRSP bucket but the cash has been replaced by the investment in Shopify.

TFSAs work the same way where you can deposit cash into the TFSA bucket and then use it to purchase investments.

So what’s the point of investing inside of these “buckets?”

I’ll get to that next.

How RRSPs Work

With an RRSP, you get a tax deduction when you transfer money or investments into the registered account. 

In the previous example where I moved $1k of cash into my RRSP bucket, it was called an “RRSP contribution.” With that $1,000 contribution I also get a $1,000 deduction on my personal taxes in the year of the contribution.

This means you’ll pay less personal tax in the year that you make an RRSP contribution. Then, the money inside the RRSP grows tax free while it’s inside the RRSP bucket.

Going back to our example, if I earned dividend income on my Shopify investment, that income would flow into the RRSP bucket. But because it’s still within the RRSP,  I wouldn’t have to pay tax on that income. 

It’s only when you withdraw funds out of your RRSP account that you have to pay personal tax on the withdrawal.

The amount that you withdraw gets added to your personal income for that year.  You then pay tax on the withdrawal amount at your marginal tax rate for that year.  

Recap of How RRSPs Work:

  1. You contribute cash or investments into your RRSP account
  2. You get a personal tax deduction when you contribute to your RRSP
  3. Your investments grow tax free inside of the RRSP
  4. Funds are only taxed when you withdraw them from your RRSP account

How TFSAs Work

With a TFSA, you transfer cash or investments into your TFSA bucket in a similar way that you do with an RRSP.  The cash can then be invested in various types of investments within the TFSA bucket.

The big difference here is that you don’t get a tax deduction when you make a contribution to your TFSA like you did with the RRSP. 

This means you don’t actually save tax in the year of the TFSA contribution.

That’s ok though, the investments inside of your TFSA can still grow tax free the same way that they would within an RRSP account.  Then when you want to withdraw the funds from your TFSA, you don’t have to pay tax on that withdrawal like you would with an RRSP.

Here’s the TFSA Recap:

  1. You contribute cash or investments into your TFSA account.
  2. There is no tax deduction when you contribute to your TFSA
  3. Your investments grow tax free inside the TFSA
  4. Funds are not taxed when you withdraw them from your TFSA

Both TFSAs and RRSPs are great savings vehicles, but depending on your situation and investment goals, one option might be better than the other.

RRSP or TFSA - Which Should You Use?

Now that we know the major differences between TFSAs and RRSPs, the question is which should you use?

Should you take your spare cash and invest it through the TFSA account, through the RRSP account or through a combination of both?

To make this decision, we’ll look a few general factors:

  1. Your investment objectives and timeframe
  2. Your current income level compared to your expected income level in the future
  3. What type of investment you’ll be investing in
  4. How much contribution room you have in each account

Investment Goals and Timeframe

So the first question to ask yourself is “what is my objective or goal when it comes to investing this money?

Are you looking to save for retirement in 25 years?

Or maybe you just want to save up for a year or two and then purchase a bright pink Tesla.

These are really different goals and it’s important to consider your overall objective before choosing one account type or the other.

An RRSP was designed to help Canadians save for retirement.  It’s right there in the name, “Registered Retirement Savings Plan.”

Due to the nature of how RRSPs work, the account is less flexible than a TFSA for short-term investing.

RRSP contributions create tax deductions, but RRSP withdrawals create taxable income.  

Using an RRSP for short-term saving can lead to potentially inefficient tax planning.  Meaning, you might end up paying tax at a higher rate than if you used a TFSA.

Summary - Investment Goals and Timeframe

Your investment goals and timeframe affect your choice of investing in either a TFSA or an RRSP.

  • Short-term for TFSA - Generally speaking, if your objective is short-term investing, a few years for example, the TFSA is likely the better choice.
  • Long-term for RRSP - RRSPs really start to shine when you’re saving for the long-term and you don’t plan on withdrawing funds until retirement.

Current Income Level vs Expected Future Income Level

Next up you’ll want to look at your current income level compared to what you expect your income to be in the future.

The reason we look at this is because contributing to an RRSP is very beneficial for someone who is currently in a high income bracket. 

The best way to explain this is to look at an example.

Income Levels Example - Francine and Arthur

Let’s say that Francine, who lives in Vancouver, earns $230,000 per year.  

This puts her in the highest tax bracket for someone living in British Columbia.

BC Federal Tax Brackets

She would pay income tax at a rate of about 54%.

Another way of saying it is that she will pay $54 of tax for every additional $100 of income that she earns.

It also means that she saves $54 dollars of tax for every hundred dollars that she contributes to her RRSP.

Courtesy of the Wealthsimple Tax Calculator

Let’s compare that to Arthur who earns $40,000 per year.  He’s in the lowest marginal tax rate for someone living in British Columbia and pays tax at only 20%.

He’ll pay $20 of tax for every additional $100 of income that he earns.

On the flip side, he’ll only save $20 in tax when he contributes $100 to his RRSP.

Courtesy of the Wealthsimple Tax Calculator

If you’re in a high tax bracket, you’ll save more tax from an RRSP contribution than someone who is in a lower income bracket.

This is how registered retirement savings plans were designed. It’s expected that people will contribute to their RRSP accounts when they are in their highest income earning years. Then when their income drops off at retirement, they can take money out of their RRSP accounts and will pay tax at a lower rate.

  • Contribute when your income is high.
  • Withdraw funds when your income is lower.

Lower income after retirement certainly isn’t the case for everyone, which is another reason why it’s good to look at all the factors when deciding how to invest.

TFSA’s on the other hand don’t have the same tax treatment as RRSPs.  There’s no deduction for TFSA contributions and no income inclusion for TFSA withdrawals.

This means that your income level matters less when using a TFSA to invest.

Summary - Income Levels

To summarize how your income level affects the investing decision, we can take a simplified view of things. 

  • RRSP - If you think you will be in a lower tax bracket when you retire than you are now, an RRSP is probably the better choice.
  • TFSA - If you think you will be in a higher tax bracket when you retire than you are now, a TFSA may be the better choice.
  • Both - If you’re not sure (and have the cash), you can always use both!

Type of Investments Held

Next up we’ll look at what types of investments you want to hold in your RRSP or TFSA account.

The government has placed some restrictions on the types of investments that can be held within TFSAs and RRSPs.

Generally, the types of investments that are allowed in a TFSA and an RRSP are the same. 

These include:

  • Cash
  • Mutual funds
  • Securities listed on a designated exchange (TSX, NYSE, etc.)
  • Guaranteed investment certificates (AKA GICs)
  • Bonds
  • Some shares in small business corporations

This is a pretty large list of investments and should cover most investors who aren’t looking for higher risk or alternative investment vehicles.

One important area where TFSAs and RRSPs do differ is how foreign dividend withholding tax is treated.

If I purchased shares in a US company like AT&T, I could earn dividend income just by owning that stock. If I held the AT&T investment in my TFSA, the foreign dividend income is subject to a 15% withholding tax.

So if I earned $100 of foreign dividend income, I would only receive $85 dollars from that dividend in my TFSA.

If the investment in AT&T was held in the RRSP, those dividends are not subject to withholding tax. I would receive the full $100 dividend in my RRSP.

This applies to foreign dividend income and we're specifically talking about US investments here.  

If you purchased shares in a Canadian company, there wouldn’t be the same type of withholding tax on dividend income.

Summary - Types of Investments Held

Here's a quick summary of how investment types affect the TFSA / RRSP decision.

  • Limitations of Both - If you want to invest in either RRSPs or TFSAs, you’re limited to a specific list of investment types.  It’s a really large list so it’s not a big deal for most people.
  • Foreign Dividend Income with TFSA 🚫 - If you earn US foreign dividend income in your TFSA, you will be subject to foreign withholding tax.
  • Foreign Dividend Income with RRSP ✅ - If you earn US foreign dividend income in your RRSP, you’re no longer subject to that withholding tax

Contribution Limits

The last factor we’ll look at when choosing between a TFSA and RRSP is the amount of contribution room that you have available.

I’ll discuss contribution limits at a high level in this article but check out the following links to find details on TFSA limits and RRSP limits.

The federal government has put limits on how much you can contribute to your TFSA and your RRSP.  There are even penalties for over-contributing to each account.

It can get a bit complicated, but for RRSPs, you create contribution room by earning income.  

The additional contribution room is equal to 18% of your earned income, up to a maximum of about $30,000 per year.  If you don’t earn any income, you don’t generate any RRSP contribution room.

TFSAs on the other hand have a set amount of contribution room that is allocated to Canadians each year regardless of how much income is earned.

Starting in 2009 when TFSAs were introduced, Canadians were allocated $5,000 of TFSA contribution room per year. The annual amount has increased over the years and in 2023 Canadians will receive an additional $6,500 of TFSA contribution room.

When you dump cash into your TFSA or RRSP bucket, it uses up some of that contribution room that you’ve built up. Where the two differ is when it comes to withdrawing funds.

If you contribute $5,000 to your TFSA and then withdraw it the next year, you’ll get that contribution room back.  Your TFSA bucket empties out when you withdraw the funds and you can fill it again.

If you contribute $5,000 to your RRSP and withdraw it the following year, you don’t get that room back in the bucket.  It’s been used up and you’ll have to generate new contribution room by earning income.

This is another reason why TFSAs are more flexible and often better for short-term investing than RRSPs.

Summary - Contribution Limits

To summarize how contribution limits affect the RRSP vs TFSA decision.

  • Avoid Overcontributions - If you have contribution room in one account but not the other, then that really makes your decision for you. Over-contributing to one account can create penalties that you’ll have to pay.
  • TFSA Short Term Investing - If you plan on investing for the short term, then a TFSA is more flexible and allows you to regain that contribution room when you withdraw funds. 
  • RRSP Contribution Room - If you withdraw funds out of your RRSP, you don’t get that contribution room back and have to generate new room.

Overall Summary

There we have it.  We looked at the general differences between RRSPs and TFSAs.

We also reviewed when you might want to use one account over the other.

As with pretty much everything related to investing it’s important to consider your situation as a whole when making decisions.  

It’s also a great idea to consult with a financial planner or investment broker to make sure you’ve got all of the information you need.

We’re also here to provide general guidance on the tax side of things so please don’t hesitate to send us your questions in the comments below.

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Article by
Paul Sharpe, CPA, CA
Originally published
December 12, 2022
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