Whether you should invest in a Tax Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP) is a question that affects almost every investor.  For almost everyone, the answer is “both.”

If you have a looming short or medium-term need (under five years), the untaxed TFSA withdrawals are likely the right choice.  For longer term retirement needs, an RRSP may be the right choice.  More factors than timing influence this decision, and, typically, more than one future purchase or expenditure is planned.

Both RRSPs and TFSAs can contain the same basket of investments whose growth and any earned income inside either account are sheltered from taxes. This includes cash and cash-like instruments, GICs, stocks, mutual funds, exchange-traded funds (ETFs), and bonds that generate interest, dividends, dividend reinvestment and capital gains.  All income earned inside an RRSP and a TFSA are sheltered from tax while they remain inside the accounts.

What is the Difference?

The two investment options act very differently when funds are deposited or withdrawn.  TFSA deposits and withdrawals have no effect on taxable income.  TFSA deposits are similar to moving funds from a chequing account to a savings account, while an RRSP deposit reduces the contributor’s taxable income.  The entire RRSP withdrawal amount is taxed as income, TFSA withdrawals are not at all.

Also, the TFSA contribution room is reinstated in the year following a withdrawal, so you can contribute, withdraw, and contribute again as long as contribution room exists.  RRSP contributions can be used only once and are not recouped following a withdrawal.

Tax Free Savings Account

Just as withdrawals are not treated as taxable income, contributions to a TFSA do not reduce your taxable income.  The return of TFSA deposits is not taxed when they are withdrawn, nor are any of the gains made inside a TFSA.

When you open a TFSA you must be 18 years of age and have a valid Social Insurance Number (SIN).  At the time of opening, you can contribute all of your lifetime contribution room at once or over a period of time.  Each year the identical amount additional contribution room is added to everyone’s lifetime total regardless of their income level.

For Canadians who have become non-residents, or for non-residents who pay Canadian tax, there are additional rules that you should be aware of. If you have foreign citizenship or ties to another country, contact CRA to verify your eligibility before opening a new TFSA or depositing to an existing TFSA.

Allowed deposit amounts are readily available from CRA, and avoiding over-contribution is very important as the penalty of one percent of over-contribution per month can prove significant.

An important distinction between TFSAs and RRSPs is that upon a TFSA withdrawal, the allowed contribution room is not lost; rather, it becomes available again in the next calendar year.

As of 2024, the lifetime cumulative limit for TFSA contribution is $95,000 per person.  Therefore, a couple could contribute a total of up to $190,000 to TFSAs if they were both eligible for the maximum contribution.  If the invested funds earned 5% returns, for example, the gain could be left inside the TFSA to grow further or withdrawn with no tax obligation on $9,000 in income.

If this income was earned outside a TFSA in a non-registered account that $9,000, the combined Federal and Provincial income tax could be as high as 53% (using Ontario as an example) causing a tax obligation of just over $4,770, leaving only $4,230 for the investors.

Anyone who has funds invested in TFSA-eligible instruments could benefit from the tax deferring and tax sheltering derived from registered accounts.

Registered Retirement Savings Plan

The “contribution room” is based on the previous year’s income level and is unique for everyone.  Each year you can make an RRSP contribution up to eighteen percent of earned income from the previous year, less any pension adjustments. Maximum contributions do exist. For the 2024 tax year, for example, the maximum allowed contribution is $31,560, up from $30,780 in 2023. The maximum amount in 2025 will be $32,490.  Any unused contribution room can be carried forward to following years to arrive at your total available contribution room.

Your total contribution room is available from CRA; you can also find this information on your Notice of Assessment or Notice of Reassessment, which the CRA sends after reviewing your annual tax return. In order to be eligible for RRSP contributions, an individual must earn an income and file a tax return, which are not required for TFSAs.

How Do They Compare?

RRSPs and TFSAs were created with different goals in mind, which explains their different behaviour in relation to taxes.

Moneysense.ca explains nicely:

“With an RRSP, you can deduct the contribution from your income, which (usually) earns you a tax refund, but the money becomes fully taxable when you take it out. The TFSA is the reverse: you don’t get a tax break on contributions, but you don’t pay tax on withdrawals either.  So, if you’re deciding between the two options, the question boils down to whether you should pay the taxman now or later.”[1]

A good guideline to follow is: “If your income (and therefore your tax rate) is greater now than you expect it to be during retirement, go with the RRSP; if it’s lower, go with the TFSA.”[2]

Most people with a high salary and secure pension plan find more benefit from the TFSA because the pension income combined with Old Age Security (OAS) and the Canada Pension Plan (CPP) could increase their income high enough to prompt a claw-back of OAS when they withdraw from an RRSP that has been converted into an RRIF.

RRSPs, however, are often the most sensible for the majority of people. Those who are not high-income earners could immediately invest the tax refund received into a TFSA and benefit from the long-term tax-free and compound earnings in both registered accounts.

Pros of RRSPs

• Immediate tax benefit
• Funds can be deposited in a Spousal RRSP to lower income taxes for a high-earning spouse and balance income in retirement to lower overall household income tax
• Enforces discipline because negative tax implications discourage withdrawals
• At death, RRSPs can be transferred to the surviving spouse without tax implications.

Pros of TFSAs

• Funds can be withdrawn from a TFSA at any time without any tax implications
• TFSA spans a lifetime, does not present any tax liability at death like an RRSP
• Unlike an RRSP, the TFSA does not have to be converted to an income plan like an RRIF

Cons of RRSPs

• The investor will have to pay tax upon withdrawal, and a minimum, ten percent withholding at source is required with a maximum thirty percent for larger amounts
• If a withdrawal is made before retirement (and not for a first time house or you or your spouse attending school), the amount will be added to employment income and the increased amount will be subject to the prevailing Federal and Provincial/Territorial marginal income tax rate
• Withdrawals result in permanent loss of contribution room
• Upon death, the entire balance of an RRSP, valued on the date of death, is considered to be withdrawn, converting the entire amount within the RRSP into income on the deceased terminal return. If the balance is large enough, it can generate significant tax liability for the estate.

Cons of TFSAs

• Deposits do not reduce taxable income
• Funds can be withdrawn from a TFSA at any time making withdrawals tempting; investors must rely on self-discipline
• Repayments of withdrawals that put an individual over the maximum contribution are subject to severe penalties; investors must self-monitor, and wait until the following year

Bottom Line

With so many different options available, choosing where to invest your savings can be confusing. We all know diversity is key for a successful investment portfolio and strategy, and the same holds true for investment vehicles, like RRSPs and TFSAs.  Both have important functions within an overall investment strategy. In an ideal situation, you’ll want to utilize both within your investment portfolio.

[1] http://www.moneysense.ca/retire/the-savings-struggle

[2] https://www.theglobeandmail.com/investing/personal-finance/household-finances/article-a-handy-rrsps-vs-tfsas-guide/