RRSP and TFSA: How they affect taxes
When it comes to saving, the debate between a TFSA account and an RRSP account is always at the forefront. Many people are confused about whether to choose a Tax-Free Saving Account (TFSA) or a Registered Retirement Savings Plan (RRSP) or both. What if I told you you don’t have to choose one or the other, and that you can have both?
What is TFSA?
A Tax-Free Saving Account commonly known as TFSA was introduced in 2009 to provide Canadians 18 years and older with a valid social insurance number (SIN) to save money tax-free.
How TFSA works
Contribution
At the end of every tax year, the government sets a limit on how much you can contribute to your TFSA for the next tax year. The annual TFSA contribution limit for 2022 is $6,000 and hasn’t changed since 2019. TFSA contribution limit doesn’t disappear which means if you turned 18 before 2009, your lifetime contribution room today will be $81,500.
Contributions made to a TFSA account are not tax-deductible meaning any amounts contributed plus any income gained in the account is tax-free, including when withdrawn.
Can you contribute to a spouse TFSA?
Yes, but not directly. You will need to give your spouse or common-law partner the money so that they can contribute to their TFSA account. Any income they earn in their account will not be added back to you.
Investing via TFSA
TFSA accounts can be used to invest to generate income. You can operate your TFSA as a savings account (cash) or use it to invest in stocks, bonds, mutual funds, and GICS depending on your risk appetite.
Benefits of investing in a TFSA
Tax-free investments on your contribution and any income earned, even if you withdraw.
You don’t need an income to contribute to TFSA
Flexible way to save since you can contribute and withdraw any time depending on your needs
Any unused contribution room throughout your life never expires
Disadvantages of TFSA
TFSA contributions are not protected from creditors under Canada Bankruptcy and Insolvency Act. In an event of bankruptcy or lawsuit, funds in a TFSA account will be accessible to settle your liabilities.
Contributions made to a TFSA account are not tax-deductible for income tax purposes.
Can you withdraw money from TFSA?
Yes, you can withdraw money from TFSA that is not locked in an investment. This means if your TFSA is just a savings account you can withdraw any time whereas if it’s for instance a GIC, you will need to wait until the maturity date. Any withdrawals made will be added back to your contribution room the following tax year.
What happens if you overcontribute to TFSA?
Contributing more than your TFSA contribution room (current year plus carried forward) you will be charged a 1% tax on your excess.
What is an RRSP?
A Registered Retirement Savings Plan commonly known as RRSP was introduced in 1957 and is a savings plan registered with the government of Canada for use towards retirement contributions. RRSP provides a tax advantage meaning once you contribute you are exempt from paying tax on that amount for the year of contribution. RRSPs are taxed on withdrawal hence the name tax-deferred account.
RRSP accounts help you to defer tax until retirement not to avoid tax.
How RRSP works
Contribution
There is a maximum contribution amount set every time you file your income taxes. For example, your 2022 RRSP contribution room is equal to the lower of 18% of your 2021 earned income, or $29,210, plus your previous unused contribution. Unused RRSP contribution room from one year is carried forward indefinitely.
RRSA contributions are made pre-tax and remain tax-free, including income earned in the account until withdrawal. If you contribute to RRSP with an already taxed income, you get your tax back when you file your income taxes at the end of the year.
Investing via RRSP
RRSP accounts can be used to invest in a wide range of investments like guaranteed investment certificates (GICs), ETFs, bonds, stocks, mutual funds and any gains earned are tax-deferred in your RRSP account until withdrawal.
Can you withdraw money from an RRSP?
RRSP is one account you should think twice before withdrawing from. This is because not only will you be charged taxes with every withdrawal but also you will lose your contribution room for good.
There are two special RRSP withdrawal programs you can utilize to access your funds:
· First time home buyers plan (HBP)
The Home Buyers Plan is a federal government initiative that allows you to withdraw funds from your RRSP account tax-free to buy or build a qualifying home up to a maximum of $35,000. You’re allowed to withdraw from more than one RRSP account as long as you’re the owner and have not used the funds to invest, that is the RRSP account is not locked. The amount withdrawn through HBP must be paid back within 15 years.
To qualify you must:
Be a first-time homebuyer
Have a written agreement to buy or build the home e.g., an accepted offer letter
Be a Canadian resident (citizen or permanent resident)
Must intend to live in the home for at least one year after buying
The potential home/house must be in Canada
· Lifelong learning plan (LLP)
A Lifelong Learning plan commonly known as LLP is another avenue to withdraw from your RRSP account tax-free. LLP program allows you to withdraw up to $10,000 per year to finance education for yourself or your spouse. This cannot be used to finance your children’s education.
To qualify you:
Must have an RRSP account
Be enrolled as a student or have received a school enrolment letter before March of the following year
Must be a Canadian resident (citizen or permanent resident)
The beauty is you can participate in an LLP as many times as you wish and even if you’ve participated in an HBP plan.
Repayments to your RRSP under the LLP program must be done over 10 years
Benefits of investing in RRSP
Your RRSP contribution is accessible under the HBP and LLP programs tax-free.
Contributing to RRSP will lower your taxable net income which is a huge benefit for high-income earners.
RRSP is protected from creditors therefore in an event of bankruptcy or lawsuit your RRSP cannot be used to cover your liabilities.
You don’t need to turn 18 to open an RRSP account. If you work summer jobs and earn income, you can file your taxes with CRA to establish an RRSP contribution room and then open an RRSP account.
Disadvantages of RRSP
RRSP contribution can only be made using your income meaning you cannot contribute to your spouse/common-law partner without affecting your contribution room.
Withdrawals will impact your other government retirement benefits
RRSP withdrawals are considered ordinary income and have no special tax benefits at retirement.
When is the RRSP contribution deadline for 2022?
The RRSP contribution deadline for the 2022 tax year is March 1st, 2023.
What happens if you overcontribute to RRSP?
If you contribute beyond your RRSP contribution limit, you will be charged a penalty tax of 1% per month. Any amounts over and above your RRSP contribution room should be channeled to your TFSA.
TFSA vs RRSP
Which is better TFSA or RRSP?
This depends on your life stage and income level. For example, if you’re younger with a low income then it makes more sense to open a TFSA account. At this age group, your financial goals will probably be to save an emergency fund, save for a car, a trip, a wedding or buy a home. Saving for all these things besides a home makes sense when done in a TFSA account.
If you’re older and in a higher tax bracket, you may want to contribute to your RRSP more to reduce your tax payable for that year. Saving to buy a home on an RRSP account makes sense because the HBP program allows you to withdraw up to $35,000 towards a down payment which is payable within 15 years.
But seriously why choose when you can have both? You can save your emergencies, big purchases, etc. using a TFSA due to the flexibility to withdraw any time and then save for retirement using an RRSP. Plus, if you max out one you can save the extra funds on the other.
Regardless of which one you choose, it’s important to invest that money instead of keeping it in cash (savings account).
Should you max out RRSP or TFSA first?
Again, this depends on your life stage and income levels. If you’re approaching retirement, it makes sense to max out RRSP first until the age of 71. If you’re younger and just starting your career, investing in TFSA first will help towards things like a wedding, a trip, emergency savings, a car, etc. And later if you plan to start a family you can withdraw from your TFSA to cover expenses for your newborn plus any emergencies that come up. If you’re young and in a high tax bracket, you might want to increase your RRSP contribution to reduce your income tax payable, concurrently with contributing to TFSA.
