By Octavia Ramirez, Founder & CEO, Paper & Coin
With the power of compounding interest, and investment vehicles like the Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) on our side, our potential to build lasting, long-term wealth is within reach. But, working towards financial freedom and flexibility requires understanding the key differences between these investment accounts, and learning how to strategically capitalize on both of them.
Here are the three important differences between the RRSP and the TFSA, and how to work each of them to your advantage to reach your goals.
- Tax implications
Despite their differences, what the RRSP and TFSA have in common is that while they seem like savings accounts, they behave differently. Simply put, the money you put in them has the potential to be invested in products like individual stocks, commodities, bonds, exchange-traded funds (ETFs), mutual funds (MFs), or cash, depending on what options you choose. These products can fluctuate depending on the stock market; depending on how they perform, the value of what you’ve invested (a.k.a., your portfolio), will either increase or decrease on any given day or week. You can expect to earn money, known as returns, or potentially lose money. And, like any earned money, whether that’s through investments or your salary, it’s subject to taxes. This is where the first difference between the RRSP and TFSA comes in.
The money that you invest in your RRSP is tax-sheltered, and tax-deferred. That means that whatever you deposit into that account will not be counted towards your taxable income within that tax year. For example, if you earned $80,000, you can invest up to 18% ($14,400) of that into your RRSP, sheltering that portion of your income from income taxes. Now, you’d only pay income taxes on $65,600 instead of the full $80,000. When you retire, whatever you withdraw from your RRSP will now be taxed at a lesser rate than it would have at the time you invested it. Therefore, you’ve “deferred” the taxes, paying them during retirement, when your taxable income will likely be less than it was during your working years.
The TFSA, on the other hand, is an after-tax investment account. Using the example above, once you’ve paid deductions, CPP, and EI on your gross salary (automatically withdrawn by most employers), and invested 18% in your RRSP, (considering you’ve chosen to do so) you can then invest into your TSFA. Any money your investments in the TFSA earn are tax-free, hence the name of the account. This is one of the only legal ways of earning money that you don’t have to pay taxes on!
2. Rules for withdrawal
Once you invest in the RRSP, you’ve locked in that money for retirement. The only reasons you’re allowed to withdraw that money tax-free before retirement are to purchase your first home under the Home Buyers Plan (HBP), or to fund your continued education under the Lifelong Learning Plan (LLP). You can take up to $35,000 towards a down-payment on your first home, and have to pay that amount back within 15 years. And, you can withdraw up to $20,000 ($10,000 per year) to go back to school as an adult, and have to pay that back within 10 years. Anything outside of those two options will result in paying taxes and penalties on anything withdrawn from your RRSP. The government has incentivized you to save for retirement, which is why they’ve put the tax deferment benefits in place. It’s not meant to be used as a savings account to withdraw from whenever you want.
The TFSA, on the other hand, has a bit more flexibility in terms of withdrawal. However, it’s worth noting that it’s also an investment account, so the money in there has earning potential! If you take the money out, it’s no longer earning, so you’re losing out on the long-term growth that could make you a potential millionaire in retirement. Depending on when you turned 18, you could have a total space of up to $69,500 in your TFSA, or $6,000 per year once you’ve maxed out your total contribution space. If that earns 5%, for example, that’s $3,475.00 per year! However much you withdraw within one calendar year, you have to wait until the next calendar year to re-invest it, and take advantage of those earnings again. So, leave that money be – but stay on top of your investments!
3. Use cases
That said, akin to the RRSP, you do have the ability to withdraw from the TFSA, if you need it. Since the TFSA is a bit more flexible, you can use this account to save up for large purchases that you know would be several years down the line. That way you can take advantage of compounding interest over the years, build up the amount in the TFSA, and then use it for something like a wedding, a new car, the trip of a lifetime, or maybe a seed fund to start that business you’ve always wanted.
You can also use this account in tandem with your RRSP for retirement savings, or to save towards your down-payment for a home, or to fund the difference in back-to-school costs outside of the LLP. Since you can only withdraw up to $35,000 from your RRSP for your first home, this is far below the average needed to purchase a home in today’s market. The TFSA and other savings accounts are a great way to supplement your RRSP withdrawal limit.
Now that you know the key differences between these two important, and highly useful investment accounts, it’s important that you put your insights to work. Remember, your investments will only work to the extent that you actually invest money into them. Be consistent as you invest into each of them, doing your best to max out each account every year … and watch that money pile up over the years!
The views and opinions expressed in this column are those of the contributor and do not necessarily reflect those of Equitable Bank. Any information provided is for information purposes only and Equitable Bank makes no representations as to the validity, accuracy, completeness or suitability of any content. You should seek the advice of a qualified professional or undertake your own research before making financial decisions.