Differentiate the tax savings between the RRSP and the TFSA in Canada
The Registered Retirement Savings Plan (RRSP) and Tax Free Savings Account (TFSA) are two programs that allow you to save money exempt from tax. The tax savings are however not identical, and there is a significant difference between the two of them. We will make a rapid comparison to understand their differences towards fiscal rules, and help you make the best decision according to your needs.
Registered Retirement Savings Plan
First, the RRSP is tax deductible, which means you can invest your gross income directly into this program. A lot of employers are actually providing it at source, where a percentage is directly retained from the periodic gross income (weekly, bi-weekly or monthly), a smart way to accumulate funds without noticing it too much. The other advantage of being tax deductible is that your taxable income becomes the gross income minus the RRSP contribution. It allows you to decrease your taxable income, and therefore reducing your payable taxes.
All investments income generated by the RRSP contribution is tax exempt. It's an effective way to minimize savings efforts for retirement, because not only is it easier to invest a bigger amount directly from the gross income, but the revenue generated would be more important since it is tax free, and it will reduce your annual taxes.
The investment income cumulated in this program won't be taxed, but in the event you want to withdraw a portion or the totality, this amount will become taxable. It is not an account you can freely withdraw without any fiscal consequences, the program is more designed for a long term investment.
Exceptionally, part of your RRSP withdrawal can be tax exempt if it aims to finance education or the purchase of your first home. Indeed, you can avoid paying taxes if the withdrawal is made through the Home Buyer's Plan (HBP). Buying a residence through the Home Buyer's Plan is available when you want to purchase a propriety if you're not already an owner (and has not been in the past four years).
Tax Free Savings Account
The TFSA on the other hand is not tax deductible; the amount you save in is net from taxes and not directly taken from the gross income. Like the RRSP, the investment income you get from this program is tax exempt, but more importantly, you can withdraw from this account without paying anything to the government. Also, in case of death, the totality of the TFSA is transferable to the partner tax free, while the same cannot be said with the RRSP.
The freedom of withdrawing free from tax associated with the TFSA may benefit projects other than retirement. For example, it can be used to finance a new startup company, renovate your home, buy a vehicle, or any other projects or purchases requiring a substantial investment. There is actually no reason not to use the TFSA when you plan to invest for a short or medium term.
There are limits to contributing to the RRSP and TFSA; after all, you can't get rich without being paid a visit by the government. However, nothing stops you from using the two programs to complete each other and maximize tax savings. When the limit is reached on one program, you continue investing in the other one.
We can now realize the advantages of one compared to the other with regards to fiscal rules. The RRSP is a great tool to invest in your retirement as a long term project with minimal effort, in addition to financing education and buying a new home, while the TSFA is preferably used to accumulate funds for several ambitious short to mid term projects. You save taxes with both programs, but in a different way, it's therefore important to understand the distinction when you invest in one or the other.