Do I Need an RRSP, a TFSA or Both?

The road to a healthy financial future can be long and winding, but fortunately, there’s more than one way to get there. When it comes to opening a registered account, many Canadians choose to put their focus and savings into either a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA). The two types of accounts have different benefits and features, and they can actually work together to help you meet your financial goals. Before jumping into either or both, it’s important to understand what these accounts are and how they can form the foundation of a healthy portfolio.

What are registered accounts?

Registered accounts are investment vehicles created by the federal government to help Canadians meet their financial goals. They make saving money more attractive by allowing you to minimize, defer or even avert some of the taxes you might otherwise be required to pay if you held assets in non-registered accounts. There are seven different types of registered accounts, including one to help you save money for a child’s education and another to help first time home buyers save for a down payment. The RRSP and TFSA are the two most popular registered accounts.

What is an RRSP?

An RRSP is a type of registered account that shelters your savings and investments, allowing them to grow, tax-free, until you withdraw – ideally in retirement. You won’t pay a dime in Canadian tax on any gains, dividends or income you make during your savings years, but when you eventually withdraw money from the account, the funds will be treated as income, and it will be taxable according to the tax bracket you’re in at that time.

In addition to your money growing tax-free for potentially decades, a big benefit of an RRSP is that contributions are tax-deductible, which decreases the amount of taxes you pay now. If you already have tax deducted from your pay cheque, contributing to an RRSP, could lower your taxable income, which means you’ll get back some of those taxes you already paid. That’s the idea with the RRSP – you save in your highest earning years when you can get back a sizable refund, and then withdraw the funds in retirement when you may be in a lower tax bracket. You can also borrow money from your RRSP for a first-time home purchase or training or education up to a certain amount tax-free, as long as you repay your RRSP over a certain period of time. The year you turn 71, you’ll need to turn your RRSP into a Registered Retirement Income Fund, which is an account you can only withdraw from.

There is a maximum amount you can contribute to your RRSP each year – either 18 per cent of your income or $31,560 for 2024 (whichever is less). You can contribute more if you have unused contribution room from a prior year. Any company pension or retirement plan contributions may also affect your contribution room. It’s important to be aware of how much room you have to contribute because generally, you will have to pay a tax of one per cent per month on your contributions that exceed your RRSP deduction limit by more than $2,000. If your excess contribution is $2,000 or less, the excess amount will not be tax-deductible, but can remain in your RRSP without penalty. If you have exceeded your contribution limit, you might consider consulting with the CRA, an accountant or a financial professional, as other rules may also apply. You can find the amount of contribution room you have in “My Account” on the CRA website.

What is a TFSA?

A TFSA is a registered account that was introduced in 2009 to help Canadians save even more.  Canadians who are 18 years or older (and have a valid social insurance number) can contribute up to a certain amount of money every year determined by the CRA – up to $7,000 for 2024. If you haven’t invested anything in the account since 2009, and you were over the age of 18 that year, you can currently contribute up to $95,000.

Similar to an RRSP, any investment income or capital gains earned on a TFSA in qualifying investments are allowed to grow tax-free. (Although income from foreign investments may be subjected to non-resident withholding taxes collected by their respective countries, including the U.S.) Unlike an RRSP, the money you invest in a TFSA is after-tax income and not tax-deductible, so you don’t receive a tax deferral. But, because you’ve already paid tax on the funds, you don’t have to pay anything to the government when you withdraw. You also don’t lose contribution room if you make a withdrawal, which you do when you remove money from an RRSP. Instead, any money taken out can be put back in, and the amount withdrawn will be added to the following year’s contribution room. Your contribution room starts to accumulate from the moment you become eligible for an account, so you can always catch up if you don’t open one right away.

How RRSPs and TFSAs can work together

There really is no “right” choice between an RRSP, a TFSA or both — just what’s right for you at a particular point in your financial journey. There are, however, a few things to consider.

RRSPs, by their nature, are well-suited for long-term savings because they’re set up in a way that discourages you from withdrawing funds until retirement. (If you do take money out early, you may have to pay a lot of income tax depending on your tax bracket, while you permanently lose the contribution room for that amount). The RRSP refund is important, too, because you can use it to manage your tax bill, invest even more in the account, or to pay down high-interest debt.

The TFSA has a few differences from the RRSP that make it a useful addition to your portfolio. The account offers similar long-term tax benefits to the RRSP, but it doesn’t cost you money or contribution room to make an early withdrawal. Because of that, a lot of people use a TFSA to invest for shorter-term goals, such as a new car or a big trip. And since you can now save close to $100,000 total in a TFSA, many are using it to save for retirement, too.

Ultimately, you may benefit most from adding both accounts to your portfolio. This can potentially allow you to lower your tax bill on a yearly basis, defer taxes on investment income and preserve access to some of your savings in the event you need it sooner than expected.