Dale Jackson

Personal Finance Columnist, Payback Time

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RRSPs and TFSAs are like those guys at work we really like but can’t tell apart.

That’s the takeaway from a recent survey from TD Bank that reveals a basic misunderstanding among Canadians over how registered retirement savings plans and tax-free savings accounts differ. 

While nearly 60 per cent of respondents agree both are important savings vehicles, 27 per cent admit they don’t know an RRSP from a TFSA.  

They both have tax advantages, but some are greater than others, depending on the financial situation of the individual contributor. And that should influence the type of investments that go inside them. 

It wouldn’t be wrong to say RRSPs favour the wealthy. Many Canadians make RRSP contributions to lower their taxable income and get a refund come tax time, but that refund is based on the contributor’s marginal tax rate. 

If you earned less than $40,000 last year, for example, you’re probably in a 20 per cent tax bracket and 20 per cent of your contribution will be refunded. If you earned over $220,000 living in Ontario, you are in a 53 per cent tax bracket, and will be refunded over half of your contribution.

Canadians with low incomes, especially young Canadians, are probably better offer socking their money away in a TFSA and holding off on an RRSP contribution for years when their income is higher. Working Canadians have a lifetime RRSP contribution limit that accumulates over the years and can be carried forward indefinitely.  

TFSA contributions cannot be deducted from income but can also favour the wealthy when it comes to retirement planning. Unlike the TFSA, where contributions and gains are never taxed, RRSP contributions and the gains they accumulate over the years are fully taxed when withdrawn. If too much money accumulates in an RRSP, the plan holder will be taxed at a high rate and could even face Old Age Security (OAS) clawbacks when minimum withdrawals are required by the government. Having a significant amount of cash in a TFSA allows retirees to draw less from their RRSPs, and in a low tax bracket, to meet their living expenses.

Withdrawing money from an RRSP early can result in a huge tax bill if you are already generating taxable income unless it’s used to purchase a new home or go back to school (provided the funds are returned over a specified time period). That’s why the TFSA is popular as a short-term savings vehicle for a down payment on a house, home renovations, or that big vacation. Funds can be withdrawn at any time (tax-free, of course) and the allowable contribution space will be renewed the following calendar year. In addition, the federal government normally adds more contribution space each year.   

If you are saving for retirement through both the RRSP and TFSA, the actual investments inside the plans can be similar and treated as one retirement portfolio. That helps when it comes to diversifying across sector and geographic lines. A healthy mix of income generating investment with growth potential will help cushion the blow of market shocks and open your portfolio up to remote opportunities. It’s important to know that just about any investment is permitted in both the RRSP and TFSA including stocks, bonds, mutual funds, exchange-traded funds, and even options.  

If you are saving for a short-term goal, or like the option of being able to draw funds before retirement, the investments inside a TFSA should be geared toward short-term investments. Long-term investments tend to ebb and flow in price, which could put you in a bind if they are ebbing when you need the cash.

That’s one reason TFSAs are so popular with day traders – especially during the recent cannabis boom and bust. Quick gains can be cashed out hassle-free. In addition, those quick gains that would have been fully taxed when withdrawn in an RRSP are, well, tax-free. 

Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email dalejackson.paybacktime@gmail.com.