TFSA, RRSP: Which to Prioritize?

Yes, it is that time of the year again! Like a lot of Canadian finance blogs, I want to describe why each exists and which factors to consider when investing in one of them or both. Before we start, you should stop by this short post about the main differences between the two and come back.

What is an RRSP?

A Registered Retirement Savings Plan (RRSP) is a retirement savings plan that you can contribute to through the Canadian federal government.

Depending on the kind of plan, you can hold a variety of products in an RRSP, including stocks, bonds, guaranteed investment certificates (GICs), Exchange Traded Funds and mutual funds. The income from these assets is tax-deferred in the RRSP until the funds are withdrawn.

How much can I contribute?
Your annual contribution limit, also known as your RRSP contribution or deduction limit, determines how much you may contribute each year. Your RRSP contribution ceiling for 2021 is equivalent to 18% of your 2020 earned income, or $27,830 (whichever is less), plus any previously unused contribution capacity, less any pension adjustments.

When is the RRSP contribution deadline for 2021?
The RRSP contribution deadline for the 2021 tax year has not ended and is on March 1st, 2022. The RRSP contribution deadline for the 2022 tax year will be on March 1st, 2023.
You’ll have to either take a lump-sum withdrawal from your RRSP, transfer the assets to a Registered Retirement Income Fund, or purchase an annuity at that point.
Think about it before taking money out
As long as your funds are not locked-in, you can withdraw from your RRSP at any time, however, withdrawals are normally included in your income and liable to tax in the year of withdrawal.

A part of your withdrawal is usually withheld and submitted to the government as a prepayment of the income tax you’ll be due for the year. Deferring withdrawals to a year when your taxable income is lower may be advantageous, depending on the amount of taxable income you make in the year of withdrawal.

RRSP withdrawals are also not added back to your contribution capacity the following year, unlike withdrawals from a tax-free savings account (TFSA).
RRSP gets you a tax deduction and lowers your taxes payable
When you contribute to an RRSP, your funds are “tax-advantaged,” meaning they are not taxed in the year you make the contribution. Any investment income obtained from investments held within the RRSP can grow tax-deferred as long as the money continues in the RRSP until it’s withdrawn.

What is the TFSA?

A tax-free savings account (TFSA) is a type of savings account in Canada that allows you to withdraw tax-free contributions and capital gains without incurring any penalties. Despite the fact that it’s called a savings account, a TFSA can hold cash as well as investments like mutual funds, stocks, and bonds. Anyone over the age of 18 in Canada can open an account, which can be used for anything.

The advantage of having an investment in a TFSA is that any income earned by the investment is tax-free. Let’s consider two savers, Joe and Jane, as an example. Joe invests C$6,000 in a 7 percent-per-year investing account at the start of the year, whereas Jane does the same but within a TFSA. At the end of the year, they will both have C$6,420, but Jane will be entitled to take all of it without penalty, whilst Joe will be taxed on the C$420 he earned in capital gain.
How much can I contribute?
In 2009, Canada launched tax-free savings accounts (TFSAs), with a contribution maximum of C$5,000 per year. In 2013, the yearly maximum was raised to C$5,500, and it stayed at that level until 2018, with the exception of 2015, when the cap was raised to C$10,000. The donation maximum was raised to C$6,000 in 2019, and it will remain there until 2022.

Your “contribution room” refers to the amount of money you may put into a TFSA. You collected contribution room for every year since 2009 that you were 18 or older and a resident of Canada, even if you didn’t have a TFSA at the time.

Any contribution room leftover from one year can be rolled over to the next. For example, if you contributed the maximum amount until 2019 when you only contributed C$3,000, you can contribute the C$3,000 from 2019 to 2020, in addition to the C$6,000 annual contribution limit for 2020, for a total of C$9,000. Similarly, if you haven’t contributed to your TFSA account since 2016, your contribution capacity for 2021 will be C$29,000: C$5,500 each for 2017 and 2018, and C$6,000 each for 2019, 2020, and 2021.

At the start of the following year, any withdrawal amount is added back to your contribution room. You won’t be able to replace the entire withdrawal amount if you contribute C$5,500 for the tax year 2021 (the contribution cap is C$6,000) and withdraw C$2,000 since your available contribution room is just C$500.

In this case, you can replace C$500 and wait until the beginning of the tax year of 2022.

Deadline for contribution
Contributions to a tax-free savings account (TFSA) can be deposited at any time.
The money grows tax-free
Because the profits on investments in the account are not taxed and withdrawals are tax-free, TFSAs allow you to save a lot of your money on taxes.

Do you have children?

Because RRSP contributions lower your taxable income, which is used to calculate the Canada Child Benefit, a larger RRSP contribution results in a greater CCB the following year. The timing and quantity of RRSP contributions offer a one-of-a-kind opportunity for tax planning.

Because of their low marginal tax rate, low-income workers are often advised to use their TFSA account for retirement savings. However, owing to the increasing CCB “tax rate” alters when a low-income family has children. Prioritizing RRSP contributions may make more sense because they will enhance your Canada Child Benefit.

Consider your investment plans, long or short

To choose between the two options of RRSP and TFSA, you have to take into account what type of investment you want to make. You have to analyze if you want a long-term or short-term investment plan. If you’re in your prime earning years, an RRSP may be a superior long-term retirement vehicle than a TFSA. Funds to RRSPs can be deducted from your income to lower your tax bill; however, contributions to TFSAs cannot be deducted. Then, TFSA investments are ideal for near-future investments.

The best is to do both

It is very normal that people decide to choose only one option, but there is nothing wrong with choosing both options, RRSP, and TFSA. If you opt for the RRSP, you will have many benefits in the long run, and if you opt for the TFSA, you will have other benefits that will help you in the short term, so having both options is a great idea.

Don’t forget your tax refunds. The tax refund is a right of all taxpayers in which they can recover the balances in favor that results in their annual returns.

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