Tax savings differences between an RRSP and a TFSA in Canada

It is important to know the differences between a Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Accounts (TFSA), which are two significantly different programs, both tax-exempt, and both will save you money.

Registered Retirement Savings Plan (RRSP)

An RRSP is tax deductible, which means you can invest your gross income directly into this plan. Many employers will contribute on your behalf by directly withholding a percentage of your periodic gross income (weekly, biweekly or monthly) and contributing the amount to the plan, a smart way to accumulate funds without much effort. Another tax advantage is that your taxable income is reduced since the RRSP contribution is deducted from your gross annual income, lowering your taxable income and helping you reduce the income taxes you will have to pay.

All investment income generated by an RRSP contribution is exempt from tax. It is an effective way to minimize your retirement savings efforts, not only because it is easier to invest a larger amount directly from gross income, but also because the income generated is higher since it is tax-free, and it will also reduce the amount of taxable income to be paid at its maturity.

The investment income accumulated in this plan will not be subject to tax, but if you wish to withdraw an amount from it, either a portion or the whole amount, this amount will be subject to tax. It is not a plan that allows you to withdraw funds freely, without tax consequences, and therefore it is designed primarily for long-term investments.

There is an exception. Part of your withdrawal from an RRSP may be tax-exempt if it is intended to finance something related to education, or for the purchase of your first property, if this is done through the First Time Home Buyers Plan (HBP).

Tax Free Savings Accounts (TFSA)

A TFSA, by comparison, is not tax deductible; the amount contributed to the plan is after tax income. Like an RRSP, the investment income it generates is tax exempt, however this plan allows you to withdraw an amount or all without having to pay the government. Another advantage, and different from an RRSP, is that in the event that the account holder has passed away, the entire TFSA is transferable to the partner (tax-free).

There are many advantages that can come from being able to withdraw an amount without having to pay taxes from a TFSA, other than retirement. You can use the amounts to finance a new business, renovate your home, purchase a vehicle, or any other project or purchase that requires a substantial investment. There is no reason not to use the TFSA when planning short or medium term investments.

Both the RRSP and TFSA plans have contribution limits, but you can use both to maximize your tax savings. We can see that an RRSP is an excellent investment plan for retirement, as a long-term project requiring minimal effort, or as an aid to finance education or purchase of a first property. A TFSA, on the other hand, is preferably used to accumulate funds for short and medium term projects.

In the end, you will be able to save taxes with both plans, but in different ways. Therefore, it is important to understand their differences in order to decide what is the best plan for you.

Source: Credit Finance Plus