Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs) are two important savings vehicles available in Canada. Each of those two savings vehicles have very distinct tax attributes. As a result, it is critical to have a good understanding of their respective tax features so they can be used efficiently while investing. First let’s consider the RRSP.
Registered Retirement Savings Plan
Overall characteristics
- An RRSP is an individual account that is registered through Canada Revenue Agency (CRA). RRSPs are designed to encourage plan holders to save for retirement;
- An RRSP is a tax-deferred account which means that investment income (interest, dividends and capital gains) earned is tax deferred until withdrawals are made. In other words, the investments can grow tax-free until withdrawals are made;
- An RRSP must be converted to an RRIF (Registered Retirement Income Fund) by the end of the year the plan holder turns 71. And starting the year they turn 72, RRIF owners must withdraw a certain amount each year;
- Provides pension holders with the ability to build up retirement savings and a larger estate through the compounding of tax-deferred income and capital gains;
Contributions
- However, contributions can only be made within certain limits. The annual contribution limit is usually indicated on the plan holder’s Notice of Assessment (NOA);
- Contributions are tax-deductible and hence provide immediate tax savings;
- Unused contribution room is carried forward and accumulated for future years;
- A plan holder can make an over-contribution of up to $2,000 without penalty. However, a penalty tax of 1% per month is assessed on the cumulative excess amount in the plan until the excess is withdrawn;
Withdrawals
- Any amount withdrawn from an RRSP is considered for tax purposes as ordinary income. The plan holder will then pay taxes on the funds withdrawn according to his/her marginal tax rate. When funds are withdrawn, a portion must be withheld by the financial institution and remitted to CRA to cover tax. The exact amount withheld to cover tax will depend on the amount withdrawn;
- However, plan holders may borrow from the plan through the Home Buyers’ Plan (HBP) and/or the Lifelong Learning Plan (LLP). The funds borrowed must be repaid according to a predetermined schedule.
Tax-Free Savings Account
Overall characteristics
- A TFSA is an individual account that is registered through Canada Revenue Agency (CRA).
- A TFSA is a tax-exempt account which means that the account holder does not pay taxes on investment income (interest, dividends and capital gains) earned within the account. In other words, the investments can grow tax-free within the TFSA;
- Provides account holders with the ability to build up retirement savings and a larger estate through the compounding of tax-exempt income and capital gains;
Contributions
- Any Canadian over the age of 18 who has filed a tax return can open a TFSA;
- Contributions are not tax-deductible;
- Contributions can be made within certain limits;
- $6,000 for 2019;
- $63,500 of total contribution room since 2009;
- Unused contribution room is carried forward and accumulated for future years;
- There is a penalty for excess contributions to a TFSA in the form of a 1% per month tax on the highest excess amount in that month
- Over-contribution penalties are assessed from the first dollar of over-contribution
Withdrawals
- Amounts withdrawn can be paid back or re-contributed in the same year if the account holder has enough unused TFSA contribution room. Otherwise the re-contribution must wait till the next calendar year or later to avoid over-contribution penalties;
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