Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) are two popular investment vehicles in Canada. Both of these accounts are designed to help Canadians save money and invest in their future. Despite their popularity, many people remain confused on when to utilize these accounts in order to maximize future benefits.
Consider Jane, who is 30 years old living in British Columbia. Having worked for a number of years she has managed to save $50,000 but has never contributed to either a TFSA or RRSP account. She would like to understand the differences between these two accounts and a better return on her investment. Her current salary is $90,000 and she believes that the average returns of her investment over her working life will be 5% when she plans to retire at 65.
Download our TFSA/RRSP Taxsheet and change the values presented in this article to match your circumstances. This spreadsheet includes a temporary API Key and the simple code needed to make calls into the Taxsheet’s Calculation Engine.
* You will be asked to accept permission to allow the spreadsheet to connect to the Taxsheet’s Calculation Engine.
With an annual income of $90,000, a deposit of $50,000 into an RRSP account would result in an equivalent reduction in her earnings for the current year. As a result, her taxes for the year 2023 would decrease by $13,165. She chooses to allocate this refund into a Tax-Free Savings Account (TFSA), where her refund can grow without incurring taxes. Alternatively, in Option 2, Jane opts to place her funds into a TFSA account. The following tables present the projected portfolio values for both options, assuming a consistent estimated annual return of 5% for Jane’s investments.
Not surprisingly, after 35 years the RRSP Option has created a larger portfolio balance because her initial tax-refund has had 35 years of compound growth. But because the RRSP withdrawals are subject to tax, how Jane intends to access these funds and her financial circumstances when she accesses them will be a factor in the taxes that will need be paid. Consider for example, these two cases:
Case 1 : Jane wants to have immediate access to her funds.
Since RRSPs only serve to defer taxes, care must be taken on how withdrawals from this account will impact marginal tax rates. The depletion of Jane’s RRSP account in a single year would result in the recognition of $275,801 income. This would likely put her in Canada’s highest tax bracket resulting in more than $100,000 in taxes being owed. With her TSFA, since all the proceeds are tax-free, no taxes will be due.
If knows that she keeps her income at $50,000/yr then she is likely to remain in a low income tax bracket. Consequentially, if she were to roll her RRSP into a RRIF and withdraw $50,000 then she would need to pay $6828 in taxes. To offset these taxes, if she withdraws that same amount from her TFSA she would be left with full $50,000 to spend. Money remaining in her accounts continue to accrue at her investment rate of return. The tables below show, by staying in a low tax bracket, Jane is able to get almost an additional year of income with her RRSP and TFSA accounts when compared to investing in just a TFSA alone.
Conclusions and considerations:
- The cases above highlight that RRSPs compares favourably to a TFSA when individual is able to maximize the differences between contribution and withdrawal marginal tax rates. This is most naturally achieved by having large incomes during contribution years and keeping your marginal tax rates low during withdrawal periods.
- RRSP are ill suited as repository for short term savings or emergency spending where large withdrawals may move the tax payer into higher tax brackets. On the other hand, they may be suitable sources of savings to balance out low income years.
- Assets withdrawn for TFSA’s can be replenished in subsequent years, RRSP balances can not.
- There are an increasing number of ways that Canadians can defer taxes on invested assets without having the rely on registered accounts.
- Large RRSP balances and prescribed withdrawals after age 71 may make it difficult to stay in lower tax brackets.
- After 65, income drawn from RRIF are eligible for income splitting.
- In the event of the death of RRSP holder’s that don’t have a beneficiary. The entire amount of the RRSP will become recognized as income and subject to marginal tax of the investor at the year of death.
- Eligibility for government benefits: Eligibility for some government benefits, such as Old Age Security (OAS), is based on income. Withdrawals from an RRSP count as income, so they can affect your eligibility for these benefits. In contrast, withdrawals from a TFSA do not count as income, so they won’t affect your eligibility for government benefits.
Download our TFSA/RRSP Taxsheet and change the values presented in this article to match your circumstances. This spreadsheet includes a temporary API Key and the simple code needed to make calls into the Taxsheet’s Calculation Engine.
* You will be asked to accept permission to allow the spreadsheet to connect to the Taxsheet’s Calculation Engine.