Tax Savings Differences Between RRSPs and TFSAs in Canada
Registered Retirement Saving Plans (RRSP) and Tax-Free Savings Accounts (TFSA) are two different programs which will allow you to save money, and are both exempt from tax. They are however significantly different from one another. We will make a rapid comparison to better understand their differences in regards to fiscal rules, and help you make the best decision according to your needs.
Registered Retirement Savings Plan
A RRSP is tax deductible, meaning you can invest your gross income directly into this plan. A lot of employers will contribute in your behalf by directly retaining a percentage from your periodic gross income (weekly, bi-weekly or monthly), and contributing the amount to the plan, a smart way for the you to accumulate funds without much effort. Another advantage of being tax deductible is that your taxable income is decreased because the RRSP contribution is deducted from your yearly gross income, decreasing the taxable income, and therefore helping you reduce your payable income taxes.
All investment income generated by a RRSP contribution is exempt from taxes. It's an effective way to minimize saving efforts for retirement, not only because it is easier to invest a bigger amount directly from the gross income, but also because the revenue generated is larger since it is tax free, and will also reduce your annual payable income taxes.
The investment income cumulated in this plan won't be taxed, but if you want to withdraw an amount from it, whether it is portion or the totality, this amount will be taxable. It is not a plan that allows you to freely withdraw from, without having fiscal consequences, therefore, it is designed mostly as 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, if it is made through the Home Buyer's Plan (HBP).
Tax-Free Savings Account
A TFSA on the other hand is not tax deductible; the amount you contribute to the plan is net from taxes and not directly taken from your gross income. Like an RRSP, the investment income it generates is tax exempt, however, it allows you to withdraw an amount or the totality from the plan without having to pay anything to the government. Another advantage, and differently than a RRSP, in the event that the account holder is deceased, the totality of the TFSA is transferable to the partner (tax free).
There are many advantages that can arise from being able to withdraw without having to pay taxes from a TFSA, other than for retirement. You could use the amounts to finance a new business, renovate your home, buy a vehicle, or any other project or purchase requiring a substantial investment. There is no reason not to use the TFSA when you plan short or medium-term investments.
Both plans, RRSPs and TFSAs, have contributing limits but you can use both plans in order to maximize your tax savings. In regards to fiscal rules, we can see that a RRSP is a great investment plan for retirement, as a long-term project requiring minimal efforts, or as help to finance education or buying a new home, for example. A TFSA on the other hand is preferably used to accumulate funds for short to mid-term projects.
In the end, you save taxes with both plans, but in different ways. It's therefore important to understand their differences so you can decide which one is best for you.