As Canadians, we have access to several government pension plans, and you may even be eligible to receive retirement benefits from your employer. For those looking to boost their retirement nest egg beyond these traditional pensions, taking advantage of government savings plans can make a significant difference over the long run. The government created both the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA) to incentivize Canadians to save more. Understanding the difference between the two is essential to deciding which plan is best for you as you plan and save for your retirement years.
The Registered Retirement Savings Plan (RRSP) has been available, and widely used by Canadians, since 1957. One of the critical benefits is that contributions are made with pre-tax dollars as funds deposited to the account reduce your taxable income. Withdrawals from the RRSP are taxed as income, making it advantageous to take out money during retirement years when your marginal tax rate is lower than during employment. This is effectively reducing and deferring the taxes due, making the RRSP a tax-advantaged account.
Unfortunately, the contributions allowed each year are not unlimited, though any unused room can be carried forward. The annual RRSP deduction limit includes the previous year’s unused contribution room plus 18% of your previous year’s income, or the RRSP limit for the year ($27,830 for 2021), whichever is less. The available room also factors in contributions made to an employer’s pension plan. How much room you have available is dependant on several factors and is highly personal, so be sure to consult with the Canada Revenue Agency (CRA) before beginning to save in the account.
High-income earners typically benefit most from contributing to an RRSP. By making contributions in pre-tax dollars, those with higher salaries can significantly reduce their taxable income while saving for retirement, and in turn, their marginal tax rate will be lower. Those with high income during their working years can take advantage of the RRSP to shift income from today into later years when it is assumed that they will have a lower income.
While high-income earners benefit the most from saving within an RRSP, many other workers can still benefit from using the account. If you have reason to believe that you are earning are higher income now than you will be in future years, then this savings strategy could be for you. Before you begin to save within an RRSP, it is recommended that you speak with your accountant to get advice specific to your situation.
The Tax-Free Savings Account (TFSA) is a relatively new savings program that was introduced in 2009. It has become a popular choice for many Canadians as it combines the benefits of tax sheltering with a withdrawal flexibility similar to a regular savings account. Contributions to the account are made with after-tax dollars, and, unlike the RRSP, withdrawals are not considered income for tax purposes. This means any income or capital gains from the account’s investments are tax-free. Over time, this can have a substantial impact on retirement savings.
Available contribution room for the TFSA increases each year and is dependant on residency rather than income. Any Canadian resident over age 18 when the program began is eligible to contribute a total of $75,500 for the years up to and including 2021. This amount is expected to increase each year that the program is available.
An additional benefit unique to the TFSA is that any withdrawals from the account are added back to available contribution room in the next calendar year. This feature allows for access to the account in pre-retirement years if needed. To determine your TFSA contribution room, check with the Canada Revenue Agency (CRA) directly.
Anyone can benefit from saving within a TFSA. The structure of this account makes it an excellent choice for those who are not confident that they will earn less in future years or have a lower income. With more accommodating withdrawal rules, this account can also benefit those who may need access to the funds before their retirement. This can actually be a major drawback for some as it can be tempting to use the savings for discretionary expenses rather than keep it invested until retirement. If you do not want to put your willpower to the test, you may want to steer clear of this account in favor of the RRSP.
In practice, the TFSA is often used in combination with the RRSP. As the tax deduction associated with the RRSP is beneficial only to a certain point, further savings can be made in the TFSA for additional retirement savings in a tax-sheltered account.
Deciding whether to save for retirement in an RRSP or a TFSA is a highly personal decision. There is no universally correct answer for which account should be used for retirement planning. The best saving strategy for you is dependant on your situation, though saving in either is more beneficial than not saving at all.
