Registered Retirement Savings Plan (RRSP) :
A Registered Retirement Savings Plan (RRSP) is a type of Canadian account registered with the Canada Revenue Agency / CRA (usually by a financial institution) for holding savings & investment assets in order to promote saving for retirement. Contributions are subject to certain restrictions and limitations set out in the Canadian Income Tax Act. A tax credit is also given for contributions made to a RRSP. Investment income and capital gains are not taxed while within the plan, and is deferred until withdrawn. An account holder may withdraw any amount from an RRSP at any time. Any amount withdrawn qualifies as taxable income, and is subject to withholding taxes. The financial institution where the RRSP is held will remit the taxes withheld to the government on your behalf upon withdrawal. You may or may not get the amount back once you file your taxes, and may even owe more taxes. Because RRSP withdrawals are considered taxable income, they may create clawbacks on government income-tested benefits such as Old Age Security (OAS) and guaranteed income supplement (GIS).
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Tax-Free Savings Account (TFSA) :
A Tax-Free Savings Account (TFSA) is a type of Canadian account registered with the CRA that provides tax benefits for saving, which came into came into effect on January 1, 2009. Contributions are not deductible for income tax purposes, but are subject to certain restrictions and limitations set out in the Income Tax Act. Investment income and capital gains are not taxed while within the TFSA, or when withdrawn. “The initial amount contributed as well as the income earned in the account (for example, investment income and capital gains) is tax-free, even when it is withdrawn.” Because withdrawals from TFSAs do not create taxable income they therefore do not create benefit clawbacks.
“You can withdraw money from the TFSA at any time and for any reason, with no tax consequences and without affecting your eligibility for federal income-tested benefits and credits.“ “Your Old Age Security (OAS) benefits, guaranteed income supplement (GIS) or Employment Insurance (EI) benefits will not be reduced as a result of the income earned or the amounts withdrawn from a TFSA.” – Canada Revenue Agency [Impact On Income Tested Benefits]
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RRSP Vs TFSA For The Long Term Is Dependent On METRs :
Whether it is more beneficial to contribute to a RRSP or TFSA depends on whether your marginal effective tax rate (METR) at the time of withdrawal (at retirement) will be higher, lower, or equal, to your METR at the time of contribution. Determining what your METR might be relative to what it is today, requires some highly recommended long term retirement planning (draw out long term retirement goals with age, sources of income, assets, etc). To get a grasp on how marginal effective tax rates impact your investment decisions, read the previous article Are RRSPs Really Beneficial?:
• If your METR is going to be higher when you contribute than when you withdraw, then contributing to an RRSP is more advantageous. You will end up paying less taxes on your investments than with a TFSA.
• If your METR is going to be higher when you withdraw than when you contribute, then the TFSA is more advantageous. You will end up paying less in taxes on your investments than with a RRSP.
• If your METR is going to remain unchanged, then a RRSP and TFSA will give the same advantage.
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In general, for low and middle income earners, TFSAs will probably be more beneficial because it is likely that their METR at contribution will be lower than at withdrawal. Most low and middle income earners assume that the their METR will be higher while they are working and lower then they are retired. During retirement the METR will be calculated based on a combination of savings, retirement income from pensions (private, government, etc), and other benefits, which then fall under various income thresholds. It is therefore not necessarily the case that METRs will be lower at retirement. RRSPs will probably be more beneficial to higher income earners because it is more likely that their METR at contribution will be higher or the same than at withdrawal, therefore taking maximum advantage of large tax refunds, while paying the same or lower METR on investment returns.
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Assets To Hold In RRSP & TFSA To Maximize Tax Features :
Many people have existing RRSPs & TFSAs, and have previously contributed to them due to a variety of reasons. In these accounts, many people also hold a variety of paper investments & asset types ranging from stocks, bonds, income trusts, GICs, etc. In general, it is more advantageous to hold certain type of investments in one account than the other, to maximize the investment’s returns and to use the tax features of the account more effectively. For some assets, neither has an advantage over the other. For certain types it may be better not to put into either account. We’ll review some features without taking into consideration an individual’s long term plan, personal METR, or investment strategy, and concentrate solely on the investment itself:
• The tax advantage of RRSPs over TFSAs really lie in the sheltering of both domestic and especially foreign income/dividends. Investments that generate foreign dividends & income should be held in a RRSP (foreign income is not sheltered in the TFSA). For example: US or international dividend paying stocks, income trusts, bonds, corporate paper, etc.
• Investments yielding high interest or other income are suitable for a RRSP, especially if it is a large amount of income. For example: high yielding bonds or corporate debt.
• Although investments that generate Canadian dividends and income have the same advantage in both RRSP & TFSA, the TFSA has the upper hand when it comes time to sell the investment for a profit. For example: An income trust or stock that generates dividends/income, but has the potential for a large capital gain.
• There is not a large tax advantage in terms of profit from capital gains with RRSPs, due to the existing (favorable) tax treatment in non-registered accounts.
• The TFSA is more suitable for high capital gain investments rather than low interest bearing GICs or savings, as you want to save the tax on the largest sum of money (not small amounts).
• Investments that are purchased purely for capital gains are better suited for a TFSA. Similarly, capital gain investments that have the potential of generating the highest overall return should be placed in a TFSA to maximize the tax-free advantage on the larger profits. For example: stocks that do not generate income.
• Low yielding GICs or savings are best left in non-registered accounts in favor of other investments (unless you do not hold any other types of investments).
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Other Considerations :
• Most banks blindly push consumers with GICs and savings for both TFSA & RRSPs by default, but I prefer using self-directed brokerages so that you have flexibility to hold a variety of investments from stocks, bonds, preferred shares/notes, ETFs, GICs, and even savings accounts from different banks & institutions. This allows you to maximize the benefits of those accounts.
• Emergency funds should be placed in regular short term deposits, GICs (cashable), and savings accounts that are outside of both TFSAs & RRSPs. Use TFSA & RRSPs for investments, as there are withdrawal & contribution conditions placed on both that restrict access to money (to varying degrees).
• If you don’t think your return on investment can be at least double your mortgage rate, then put the money into your mortgage. It is both guaranteed and tax-free, so think of it as a risk-free & tax-free investment that is yielding whatever your mortgage rate is. For people who know little about investing, this is actually the best returning investment. Just make sure you have enough emergency funds (don’t pour every penny into your mortgage).
• If you only have enough money to contribute to one account, then the TFSA may be better than the RRSP, as you will gain a tax advantage regardless of your METR. With the RRSP the tax advantage may or may not exist in the future (depends on your future METR).
• If you do not have a long term retirement plan drawn out, or don’t know what your METR in the future will be like relative to what it is today, then contributing to a TFSA is the safer choice. The flexibility of the TFSA allows you to withdraw the funds tax-free, and contribute to a RRSP (locked) if you later determine that your METR will be lower in the future.
• If you don’t have money and really need to use the tax credit from a RRSP contribution, then RRSP may make sense as a temporary solution (dodge a bullet today, but take one later of a potentially undetermined size).
• Contribute to a RRSP if you receive matched contributions (free money) from your employer.
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What Do I Hold In Each Account :
As an example, in my RRSP account I allocated mainly high yielding US & international dividend paying stocks, and US corporate debt. To a lesser degree I allocated some Canadian equity.
In my TFSA I hold Canadian income trusts, Canadian dividend paying stocks, and Canadian equity. To a lesser degree I hold US equity.
As mentioned in the previous article Are RRSPs Really Beneficial? I have long stopped contributing to RRSPs, for a variety of reasons including flexibility as well as expectations of higher METRs in the future. Therefore, I max out my TFSA each year, and as a result I have also allocated a combination of International, US, and Canadian stocks (equity and dividend paying) outside both registered accounts. GICs and other similar cash products are held strictly outside RRSPs and TFSAs.
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Allocating between a RRSP and TFSA is highly customized to an individual’s specific investment holdings and situation. Usually, a blanket strategy does not work well. This article is not an exhaustive one, but is meant as a general guideline to give investors some direction and an area to do more research for their own personal tax situation and investment holdings.
Also beware of RRSP Tax-Free Withdrawal Schemes/Scams. See the CRA Tax Alert bulletin:
http://www.cra-arc.gc.ca/nwsrm/lrts/2009/l090317-eng.html
Thanks and Happy Investing! – The Investment Blogger © 2011
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I’ve been asked a questions which might be helpful to other readers.
Q: If I have my money in a RRSP mutual fund, can I switch it to another RRSP mutual fund without getting taxed?
A: Yes it is possible without getting taxed.
- At a branch, the mutual fund would be sold, but the proceeds would go into a regular RSP account, then the money would be used to purchase the other RRSP mutual fund.
- Assuming you have passed the minimum holding period (if any), you wouldn’t need to pay certain fees. But there may be selling and other fees associated (back load, etc.). Usually, if its a big retail bank like BMO, RBC, TD, Scotia, CIBC, etc, there isn’t any other fees. But you should check first.
- You can even switch to a different bank. It is called a “registered transfer”. It could be done in a number of ways, where it is sold off first then the cash transferred to another RRSP account, or it is transfered “as is”.
- The important thing to note is that the money should never be taken out of an RRSP account and into a non-registered one, even if temporary. The second it goes into a non-registered account you will pay tax. It must always be directly from RRSP to RRSP account (saving/brokerage/etc).
It has come to my attention there is some confusion about TFSA and foreign income. Foreign income in the TFSA is subject to withholding taxes (i.e. must pay the withholding taxes, like on US dividends). What’s left over after paying that, is tax sheltered (i.e. not taxed).
There has also been some confusion about holding “savings accounts” within discount brokerages. Some financial institutions such as Manulife have “investment savings accounts” which you can purchase, much like a mutual fund or money market fund. You can buy and sell these within your discount brokerage account. They usually pay a bit more interest than the average bank savings account. The Manulife one that I had purchased once in my brokerage account had the symbol MIP510. Although I wouldn’t recommend to hold such low interest bearing instruments within a TFSA as an investment.
Their webpage for those products are https://hermes.manulife.com/canada/repsrcfm-dir.nsf/Public/AB0403E/$File/AB0403E.pdf
And yes, within a brokerage account you can purchase GICs of other financial institutions (i.e. Scotia, CIBC, Home Trust, etc). It is not widely known or used. With TDWaterhouse (brokerage I use), you have to call a TDWaterhouse rep.
Can I withdraw gains made from my locked in rrsp account.
From what I understand, you are not allowed if it its a locked-in retirement account or LIRA. When you hit 71 you also must transfer the money to a Locked-in Retirement Income Fund LRIF, Life Income Fund LIF, or Life annuity. These also have their own withdrawal restrictions.
Also take a look here http://www.fsco.gov.on.ca/en/pensions/lockedin/faq/Pages/locked-inaccountchanges.aspx