Limited money to invest? How to choose between a TFSA and RRSP

The sky-high cost of living means Canadians have to spend more of their income on basic necessities, leaving less money at the end of the month for voluntary spending and future savings.

This was demonstrated in a recent poll by Angus Reidshowing that 19 percent of respondents had deferred or stopped making contributions to their Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) in the face of rising inflation.

For an individual who may only have enough funds to fund one account or the other, one of the main differences between an RRSP and a TFSA is their tax implications, since both accounts can hold the same types of investments.

“When tax becomes the differentiator, and that’s what the decision needs to be based on – a tax method, not an investment method – then the marginal tax rate matters. How does your marginal tax rate compare today to what you expect going forward?” Tony Salgado, President and Founder of AMS Wealth, said in a phone interview.

He said those with a low marginal tax rate are probably better off putting the money in a TFSA because the immediate tax savings from an RRSP are minimal.

Funds contributed to an RRSP are tax deductible and if the funds are withdrawn, they are subject to income tax. In contrast, contributions to a TFSA are not tax deductible and, in turn, the money and any capital gains are not taxed when withdrawn from a TFSA.

Jessica Moorhouse, a financial advisor and host of the More Money Podcast, said the first thing investors should consider when deciding which account to use is whether the money is for retirement or a more near-term goal.

“TFSAs are great for shorter-term savings/investment goals because you have the flexibility to withdraw that money from the account tax-free (since you put dollars into the account after taxes). So you won’t be penalized for withdrawing money like you would with an early RRSP withdrawal, which would be subject to withholding tax,” she said via email.

“RRSPs were really designed for long-term investments for your retirement, although they could also be used for a first-time homebuyer plan or a lifelong learning plan if needed (although they should generally only be used for future retirement savings).”

Given the uncertainty in the economy and the high cost of living, Frank Gasper, the founder of CSR Wealth Management, said he usually prefers the TFSA because it offers more flexibility in terms of withdrawals and gives the client better control over their cash flow because investments are tax-free allowed to grow.

To leverage both accounts, he said one strategy is to put the funds in a TFSA where the money can grow. Then, as the March 1 RRSP submission deadline nears, the individual can withdraw the money from the TFSA and put it in their RRSP to receive the tax refund.

The strategy allows the client to take advantage of the TFSA’s tax-free growth while still having easy access to the funds, and then take advantage of the tax refund from the RRSP contribution.

“If the concern is that I might need that money or this is extra money and I’ll never need it until retirement, it still won’t hurt to throw it in the TFSA first,” Gasper said over the phone.

Individuals should be aware of how TFSA withdrawals affect their contribution space for the year. All TFSA contributions — including replacing or re-contributing withdrawn money — all count toward the annual contribution limit, which was $6,000 in 2022. However, no contribution space is lost, it is simply carried over to the next year.

ESTATE PLANNING

“Never offend with a big RRSP or [Registered Retirement Income Account]. That’s the ultimate price to pay,” Salgado said.

The tax differences between an RRSP and a TFSA also extend to the death of the account holder.

In general, monies in an RRSP are assumed to be paid out on death and taxed in full, which in most cases has a huge tax impact, unless a spouse is named as a beneficiary and the monies are transferred to their RRSP. TFSAs are not taxed on the death of the account holder.

“The money in an RRSP also goes to a surviving spouse. But if it doesn’t, and it goes to a beneficiary, then it’s taxable. Additionally, it could be considered for parole depending on the size of the RRSP and provisions in the will,” Gasper said.

“A tax-free savings account is not notarized and goes directly to the beneficiaries. It’s a great opportunity for estate planning, both from an heir’s standpoint and from a “passing on the money to the beneficiary’ standpoint, since the money goes to the beneficiaries completely tax-free.”