Tax-Free Savings Accounts and Registered Retirement Savings Plans are the two most highly marketed types of savings instruments by the big banks. For the most part, their differences are rarely highlighted, making them fairly indistinguishable to most of us. You may have heard statements like “you should contribute to your RRSP, it will reduce your taxes” or “Contribute to your TFSA today and earn 1.5% on new deposits”. But what do these phrases really mean, and what is the true purpose of using these accounts.
The best place to start is by identifying that neither of these types of accounts are an account in and of itself. One way to visualize this is to think of a TFSA or an RRSP as an umbrella that protects the money held in the accounts from specific tax regulations.
Not Just Another Savings Account
The next most important and under marketed feature of these accounts is the fact that just because they are accounts designated for savings, it does not mean that you must hold the funds in a traditional savings account – think eAdvantage or Bonus Savings Account paying 0.05% annually. You are not even limited to holding low risk fixed income securities – a fancy way of saying GIC’s (Guaranteed Income Certificates), think Government of Canada bonds paying you 0.7% interest for the next 10 years. Have you read our post on inflation? If you haven’t, check it out because you’ll understand that you’re actually losing money by holding these low percentage rate, long term bonds. While the amount of money in your savings account will increase, the amount of things you can buy with that money will decrease due to inflation – you will also be missing out on the benefits of compound interest at a higher rate.
Government regulations allow you to hold a wide range of accounts under the umbrella protection of a TFSA or RRSP. Within them you can hold a brokerage account, a place for buying and selling securities (stocks, bonds, mutual funds, exchange traded funds, etc.). Now is an excellent time to surf the web (check out tips and experiences on our website) to gain a better understanding and familiarity with investing concepts so that you feel comfortable making financial decisions for yourself. If you don’t feel comfortable investing on your own yet, don’t be afraid to ask questions so that you can decide what the best way forward is for yourself. And if you don’t feel comfortable enough yet with the amount of risk taking involved in securities investing, you can always hold the cash in a DISA (Daily Interest Savings Account) which is just one type of savings account available under the protection of a registered account, as mentioned above.
Main Differences Between a Tax-Free Savings Account and a Registered Retirement Savings Plan
While both of these types of accounts allow for certain tax benefits, they are best utilized when they are used for their intended purposes. TFSA’s make a good vehicle for both short and long term savings, while Registered Retirement Savings Plans should be used for long term savings (hence the word retirement) or the purchase of your first home. FACT: When you withdraw money from an RRSP you must add that amount to your taxable income for the year (only fair since you were able to reduce your taxable income by that amount when you contributed that money to the account). Another difference is that once you remove money from an RRSP, that contribution room is gone and can never be recontributed.
Check out the table below outlining some of the main differences between TFSA’s and RRSP’s. Stay tuned for more articles explaining the benefits of these accounts and how to get the most out of them. As always feel free to email us or comment below with questions or comments you have.
|What is the account designed for?||Short and long term savings||Long term savings or completing a major purchase (first house)|
|Who can open and use an account?||Only people over the age of 18||Only people who have earned employment income (this year or in previous years)|
|Is there a limit to how much you can deposit each year?||Yes, the Federal Government sets an annual limit every year (usually about $5,000)||Yes, 18% of your employment income, up to $24,930 annually|
|Does the contribution room carry forward to future years if the maximum amount is not contributed this year or in previous years?||Yes||Yes|
|Do contributions reduce the amount of income tax you pay this year?||No||Yes|
|Do you have to pay income tax on the money you withdraw?||No||Yes (Unless you are buying your first house as a part of the Home Buyers Plan)|
|Do you have to pay taxes on the money made from investments?||No||Yes|
|When do you pay the taxes on the money you made from the investments?||Never||Only when you withdraw money from your account, not when you sell the investments|
|Can money you withdraw from the account be recontributed?||Yes, but you have to wait until the next calander year||No, once money is withdrawn that amount is removed from your contribution room|