Episode #61: RRSP vs TFSA? The Strategy To Lower Your Taxes and Build Wealth
If you live and work in Canada you currently have access to two amazing investing accounts that offer you incredibly powerful tax benefits that will allow you to grow wealth (without paying tax on it) over the course of your working life. These accounts are called the TFSA (tax free savings account) and the RRSP (registered retirement savings plan0. It’s extremely common for people to misunderstand and misuse these accounts, so in today’s episode I’m going to walk you through the basics of what each account is, the main differences between these two accounts, which account you should prioritize saving and investing in at different stages of your life, as well as the ultimate investing plan you can work towards to use both accounts to their full potential.
The RRSP
Even though this account is called a registered retirement savings plan, it’s actually intended to be used as an investing account, and NOT a savings account. This account allows you to make a contribution, invest that money you’ve contributed, and then that money can grow and compound completely tax free. To compare, if you put your money into what’s called a ‘non-registered’ account your earnings are at times subject to taxation, which cripples your growth potential compared to investments made in an RRSP account.
The RRSP also offers what’s called a ‘tax deferral’. The money you contribute to your RRSP is considered ‘pre-tax income’, which means that you haven’t paid tax on this income yet, and if you contribute it to your RRSP then you don’t pay tax on that money! This has the effect of lowering your taxable income, which means you’ll get a substantial tax refund if you do this.
The amount that you’re allowed to contribute each year is up to 18% of your previous year’s income, and there is a cap to the contribution limit for high income earners that’s set annually. If you haven’t been maxing out your RRSP the available contribution room from previous years rolls over. Some employers offer what’s called an RRSP match, which will help you increase your savings percentage if you can take advantage of this.
If you don’t know how much you can contribute to your RRSP account this year, your CRA MyAccount will tell you how much contribution room you have available. Make sure you know your contribution limit, because you’ll be penalized for over-contributing to your RRSP!
When it comes to withdrawing money from your RRSP when you’re retired, you will pay income tax on it, but the theory is you should be in a lower tax bracket in that stage of your life, which means you’ll pay less tax overall. This is a pretty powerful tax advantage, because taxes are the single largest expense that most Canadians have, so lowering the amount of tax you pay can save you a lot of money overtime.
The RRSP account is strict when it comes to withdrawing your money before retirement. You can withdraw it, but you’ll pay tax on that money and lose the contribution room, which will have a huge impact on your ability to prepare for your future. There are loopholes that allow you to take money, for example The First Time Homebuyer’s Plan, but I’m not going to get into those in this episode as this is a quick overview and comparison of two accounts!
If you want to learn about your RRSP account in more detail, I’ve created an entire episode about RRSP’s which is linked here. Make sure you catch this episode too (available on youtube, apple podcasts, spotify, or the blog) to learn more about this account!
The TFSA
TFSA stands for tax free savings account, and again even though it says the word ‘savings’ in the name, this is also an investing account. You’re doing yourself a huge disservice if you’re using this as a savings account and not using it to invest for your future!
Like the RRSP, the TFSA allows the money you’ve invested to grow tax free. Unlike the RRSO, the money you contribute to the TFSA is considered ‘after tax dollars’. This means you’ve already paid tax on that money, so it doesn’t offer you a tax deferral, BUT the best tax perk of the TFSA is that when you withdraw that money in retirement you don’t pay income tax on it. That means that if you withdraw $50,000.00 a year in retirement as your income, the CRA will see your income as being $0, which means you don’t pay tax on it.
The TFSA is also a much more flexible account about allowing you to withdraw money from the account before your retirement. I have to say though that you don’t want to take money out of your TFSA early because this is such a powerful account specifically for saving for your future. You don’t need tax free investment compounding and growth to buy a car, but you DO need that to prepare for your eventual retirement. So, even though it’s easier to take money out of this account, don’t do it, you’ll be significantly impacting your ability to retire comfortably if you do.
The amount that you can contribute to your TFSA is a set amount determined and announced by the government each year. This year the contribution limit is $6,500.00 and in theory this amount is supposed to change along with inflation each year. The contribution room in your TFSA starts accruing when you turn 18, and just like the RRSP the contribution room carries over each year if it isn’t used. Again, if you’re unsure of your contribution limit, you can check the CRA website to see how much contribution room you currently have. If you want to learn about this specific account in more detail, I’ve created an entire episode about TFSAs which I’ve linked here and you can checkout on youtube, apple podcasts, spotify, or the blog.
Comparing the RRSP and TFSA
So, now let’s do a quick comparison of the RRSP and the TFSA.
1. The RRSP contributions are based on your last year’s income (18% of your previous year’s income). The contribution room rolls over if you don’t use it, and there’s a maximum contribution amount you don’t want to exceed or you will be penalized. The TFSA contributions are set each year by the government, this contribution space also rolls over if you don’t use it, and again you don’t want to exceed the contribution limit or you’ll be penalized.
2. Some employers offer an RRSP contribution match, as far as I know this doesn’t exist for TFSAs
3. The money you contribute to your RRSP is considered pre-tax income, and this creates a tax deferral, meaning you don’t have to pay tax on the money you put into your RRSP and you’ll get a good tax refund if you contribute to your RRSP. The money you contribute to your TFSA is considered ‘after tax income’, which means you’ve already paid income tax on that money. Contributing to your TFSA does not give you a tax refund.
4. Once you’ve contributed to both your RRSP and TFSA, the money is ‘tax sheltered’, meaning your investments are allowed to grow and compound tax free. This is an incredible advantage to building long term wealth that both of these accounts offer you.
5. When it comes time to withdraw money in your retirement, the money you take from your RRSP will be taxable according to the income tax bracket that you’re in, just like the money you earn from your paycheck right now. On the other hand, the money you withdraw from your TFSA is tax free, you don’t pay tax on that money, whatever you withdraw you get to keep all of it.
6. If you’re looking at withdrawing money before your retirement (which, really try not to do this from either account) it’s much easier to withdraw money from your TFSA. You can withdraw from your TFSA without penalty, and are allowed to put your contributions back into the account the next calendar year. If you withdraw early from your RRSP you’ll be penalized by having to pay tax on that money and losing the available contribution room. There are a couple of loopholes that do allow you to withdraw the money from your RRSP like the first time homebuyer’s plan and the lifelong learner’s plan.
Overall, the main benefit of both accounts is the same. They both allow you to grow your wealth through investments tax free while the money remains in that account. But, both accounts have slightly different rules, and most importantly different tax implications that can be used strategically to minimize the amount of tax you pay over the whole course of your life. If you’re currently earning the same amount now as you think you’d like to withdraw to live on in retirement, then the tax benefits are a wash overall, neither account is better than the other, at the end of the day you’ll end up with the same amount of money when you withdraw from either account.
Which account should you prioritize?
Now, the question that many people have is which account should they prioritize? There is a detailed strategy around this, which you’re best to work with a good accountant to work out, but I’m going to walk you through the 3 most important points you want to consider overall if you have limited financial resources and you need to decide which account to contribute to.
The first thing to consider is, does your employer offer you an RRSP match? If so, then absolutely 100% contribute that amount to your RRSP first, because this is free money your employer is offering you and it’s basically the only guaranteed immediate 100% return on investment the world will ever offer you.
The next thing to consider is what your income is, and what stage of your career you’re at. If you’re at the beginning of your career, this likely means you’re earning less than you will be in the future, and probably less than you’d like to have to live on in retirement. If this is the case then it’s better from a tax perspective to invest into your TFSA. The same applies if you’re earning less than around $50,000.00, or somewhere in the realm of $50,000-$90,000, the TFSA is likely your better bet.
If you’re earning a high income right now, that’s higher than what you think you’d like to withdraw in your retirement, then it’s best to invest into your RRSP first. This will give you a tax refund which you also want to invest to take full advantage of the powers of the RRSP, which leads me to the last point in today’s episode which is the ultimate investing plan to maximize your RRSP and TFSA.
Now this strategy isn’t available to everybody right away depending on your income and lifestyle expense requirements, but it’s important that everyone understand this because this is what you want to eventually work towards. What you want to do ultimately is to first contribute to your RRSP enough to get your employer match, then max out your annual contribution room available in your RRSP from there. These contributions will give you a tax refund, and you want to take this money and invest it into your TFSA first, then again top up whatever contribution room is available in your TFSA from there as well. This maximizes the power that both the RRSP and the TFSA offer you, and will set you up for a healthy retirement portfolio that can fund a pretty great lifestyle one day.
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