This is a question that comes up regularly in financial planning and tax planning circles. But before we attempt to answer the question, we need to know the difference in the tax treatment between these plans.
Although some commentators call the first 60 days of the year the “RRSP season”, that is not really true. As noted below, to get a tax deduction for an RRSP contribution in a year, you can make the deduction in the year or within 60 days after the year. Since an RRSP and TFSA earn tax-free income, contributing to your RRSP and TFSA should be year-round tax plans.
An RRSP (registered retirement savings plan) is essentially a personal “money-purchase” pension plan, usually set up with a trust company or an insurance company.
Your contributions to the RRSP are deductible in computing your income, subject to the limits described below. The RRSP can invest in various investments, including publicly traded stocks, bonds, mutual funds, GICs, and so on.
The income earned in your RRSP is completely tax free while in the plan. However, when you withdraw the funds, they are fully included in your income for tax purposes.
The contribution limit for 2022 is:
- Your unused contribution RRSP room from previous years, plus
- the lesser of 18% of your “earned income” for 2021 and the general dollar limit for 2022 of $29,210 (which is indexed each year to inflation), minus your “pension adjustment”, which basically measures contributions to an employer registered pension plan, if you have one (if you don’t have one the pension adjustment should be zero).
“Earned income” is basically your employment or net business income, with some additional types of income allowed as well.
The “unused contribution room” component means that if you don’t fully contribute in a year up to your RRSP limit, you can carry that deduction room forward indefinitely.
The contribution is normally made in the relevant year, but the deduction for a given year is available for any contributions made within 60 days after the year. So for the 2022 year, you can contribute during 2022 or by March 1, 2023 and claim the deduction in 2022. (Note that for next year’s deduction, the deadline will be February 29, 2024, not March 1!)
A TFSA (tax-free savings account) is normally set up with your bank or trust company.
Similar to the RRSP, it can invest in stocks, bonds, mutual funds etc.
Also similar to the RRSP, there is no tax payable on the income earned in the plan.
The difference is that there is no tax deduction when you contribute to the plan, and no income inclusion when you withdraw from the plan.
The monetary limits do not depend on earned income (as noted above, the RRSP limits do depend on this). There are flat monetary limits each year, which accumulate if you don’t use them up.
In 2009, when TFSAs were introduced, the annual limit was $5,000, and this amount has been indexed annually to inflation, but rounded to the nearest $500 (there is one exception, in 2015 when it was bumped up to $10,000). For 2022, the limit is $6,000.
In addition, if you withdraw from the TFSA in one year, the amount of the withdrawal is added back to your contribution room starting with the next year.
Unlike the RRSP, you have to be 18 years or older to set up a TFSA.
Like the RRSP, any unused contribution room can be carried forward indefinitely. So if you were born before 1992, the cumulative total you can contribute as of 2022 is $81,500. (See the table in our March 2022 issue for the maximum if you were born after 1991.)
Which is better on after-tax basis?
If you are in the same tax bracket in the year of contribution and the year you withdraw the funds, the RRSP and TFSA are economically equivalent.
Although an arithmetical formula can prove this, you can think of it conceptually this way. Both plans earn tax-free-income while in the plan. The TFSA provides no deduction for the contribution but no inclusion upon withdrawal, while the RRSP provides a deduction for the contribution but an inclusion upon withdrawal that effectively “offset” each other, providing the same result as the TFSA.
You are in a 40% tax bracket in 2022 and the subsequent year of withdrawal, which we will assume is 2028.
You want to contribute the after-tax amount of $10,000 of your employment income this year to one of these plans, or both. Assume the contribution doubles by 2028, and then you withdraw the entire amount.
RRSP contribution: If you decide to contribute $10,000 now, you get a $10,000 deduction so there is no tax on that amount for 2022. This means you can contribute the entire amount of $10,000. The $10,000 grows to $20,000 by 2028, and when you withdraw, you pay $8,000 in tax (40% rate), leaving you with $12,000 after tax.
TFSA contribution: There is no deduction in 2022, so your after-tax amount of employment income is $6,000 ($10,000 net of the 40% tax in 2022). So you can contribute $6,000. That doubles to $12,000 by 2028 when you withdraw, with no tax, leaving you with $12,000.
So you are left in the same after-tax position either way.
However, if you are in a different tax bracket in 2028, the two plans are not equivalent on an after-tax basis.
Lower tax bracket in 2028:
Assume the same facts as above.
Except assume you are in a 30% bracket in 2028. With the RRSP option, you pay $6,000 in tax in 2028. So when you withdraw the $20,000, you are left with $14,000.
With the TFSA option, your tax bracket is irrelevant since the withdrawal is tax-free. So, as above, you are left with $12,000 in 2028.
Higher tax bracket in 2028:
Next assume you are in a 50% bracket in 2028. With the RRSP option, you pay $10,000 in tax in 2028. So when you withdraw the $20,000, you are left with $10,000.
With the TFSA option, again your tax bracket is irrelevant since the withdrawal is tax-free. So, as above, you are left with $12,000 in 2028.
The practical problem is that we often don’t know whether our tax rates will be higher or lower in the year of withdrawal.
Of course, if you are fortunate enough to be able to contribute the full limit amounts to both your RRSP and TFSA, you should do that.
Another related issue comes up if you withdraw the amounts when you are 65 years old or more. The RRSP option means you include the withdrawal in your income. So that means, depending on your income, you might be subject to the Old Age Security “clawback tax”. It could also affect your age tax credit, which is phased out after a certain amount of income. (On the positive side, income from the RRSP, or from a RRIF to which it is converted, may generate the “pension credit” on your return.) With the TFSA option, these issues don’t arise since the withdrawal is not included in your income. So that is another issue to consider, in addition to your tax rates in the year of contribution and the year of withdrawal. But again, this is often hard to predict.
Potential for income-splitting with spouse or partner
One tax plan that can be considered for either an RRSP or a TFSA is the potential to split income with your spouse (or common-law partner).
Under the RRSP rules, you can contribute to either your RRSP or your spouse’s RRSP (provided it is set up with the institution as a “spousal RRSP”), and you can claim the tax deduction to reduce your taxes. Your spouse will benefit from the tax-free income while it is in the RRSP. Furthermore, if your spouse is in a lower tax bracket than you when they withdraw the funds, you will obviously save tax as a couple. There is one caveat: Your spouse must wait until the third year after the year in which you make your contribution to withdraw. If the withdrawal is made earlier, there is an attribution rule that provides that it will be included in your income.
In 2022, I am in a 50% tax bracket. I contribute $20,000 to my spouse’s RRSP (which has been set up as a spousal RRSP).
I can deduct the $20,000 from my income, which saves me $10,000 in tax because I am in a 50% tax bracket.
The funds in my spouse’s RRSP grow to $30,000 by 2027, and they withdraw the amount. My spouse is in a 20% tax bracket, so they pay $6,000 in tax, leaving $24,000 after tax. Assuming I was still in a 50% tax bracket, obviously I would have paid more tax and be left with less after tax.
Because of the attribution rule, if my spouse withdrew in, say, 2024, the amount would be included in my income and the income splitting opportunity would be lost.
Under the TFSA rules, you can similarly give money to your spouse to contribute to their TFSA. Although there is no attribution of income while the funds are in the TFSA, future attribution is not prevented if funds transferred to the TFSA are withdrawn by the spouse.