What is an RRSP and a TFSA? 

A Registered Retirement Savings Plan (RRSP) is a savings plan where people save money for their retirement. The contributions made to an RRSP account reduces your income by that amount because the funds in an RRSP are tax-deferred. The growth on the plan is also tax-deferred providing the funds stay in the plan. Tax is paid when the money is withdrawn later upon retirement. 

A Tax-Free Savings Account (TFSA) is an investment account where people can set money aside tax-free throughout their lifetime. The contributions made to a TFSA are not tax-deductible. However, any income earned in the account is tax-free even when the funds are withdrawn. 

There’s a limit to the amount of contributions you can make to an RRSP and a TFSA. Failure to adhere to the contributions limit will result in penalties so it is important that you know your contribution limits and adhere to staying below them. 

The TFSA inception was in 2009. The contributions limit from 2009 to 2012 was $5000 per year. The limit increased to $5500 for 2013 and 2014, and then to $10,000 in 2015. A change in government resulted in a reduction in the contribution limit so it was reduced back to $5500 for 2016 to 2018. The contribution limit was increased again in 2018 to $6000 and remains the same for 2021. 

The year to date contribution limit for each Canadian 18 years and older is $75,500
i.e. (4 x $5,000) + (2 x $5,500) + (1 x $10,000) + ( 3 x $5,500) + ( 3 x $6,000). 

The RRSP inception was in 1957 and the contribution limit has always been based on the following criteria: 

The lesser of the two following items: 

  • (A set) percentage of your earned income in the previous year
  • the annual RRSP limit set for that year  

In 1957 the contribution limit was the lesser of: 

  • 10% of your earned income for 1956
  • maximum contribution of $2500 

For 2021 the contribution limit is the lesser of: 

  • 18% of your earned income for 2020
  • maximum contribution of $27,230 for 2020 

Since the contribution limit for an RRSP is dependent on different variables such as income, the annual RRSP limit, and percentage contribution set for each year, it’s more difficult to calculate your year to date contribution limit. However, each year you file your tax return, your notice of assessment shows you what your limit is, and the amount of contribution room you have.  

Should I contribute to an RRSP or a TFSA for my retirement? 

Personally, I prefer to contribute to a TFSA since I prefer to pay taxes on the seed than on the harvest. But there are times when I contribute to my RRSP to reduce my tax obligations so that I’m not in jeopardy of owing the government more taxes when I file my income tax return. 

So my answer to this question is: It depends on the answer to the following questions. 

  1. Do I owe taxes from the previous year?
  2. Do I want my money to be held hostage because I don’t want to pay the taxes when I withdraw?
  3. Do I want the flexibility to be able to withdraw my money but have the room to put it back in subsequent years?
  4. Do I plan to retire poor? (pay minimum taxes later if your retirement income is low) 

Any funds withdrawn from an RRSP attract withholding tax. Depending on the amount withdrawn, the financial institution may withhold 10% ($5000 or less withdrawal), 20% ($5001 to $15000 withdrawal), or 30% (greater than $15000 withdrawal) in taxes.  

The only withdrawals that are exempted from the withholding tax are funds for: 

  • (First time) Home Buyers Plan (HBP – $35000 withdrawal limit – 15 years to repay your RRSP)
  • Lifelong Learning Plan (LLP – $10,000 yearly withdrawal limit for 2 years – 10 years to repay your RRSP) 

So, the only time I contribute to my RRSP is when my answer to question 1 above is YES! 

Why pay the government more taxes if I don’t have to? 

Apart from retirement purposes, some people rigorously contribute to their RRSP, because of the potential tax refund. But I believe if you’re not planning on retiring POOR, the benefits that you think you receive from a tax refund today could backfire upon retirement. 

Let’s look at an example to explain why some people favour RRSPs. 

Supposed your income was $100,000 for 2020, and let’s say your effective tax rate is 25%. You would have paid $25,000 ($100,000 x 0.25) in income tax for the year 2020. Now suppose you make an RRSP contribution of $10,000 before the March 1, 2021 deadline. Because the $10,000 would not be considered as taxable income, your effective income for 2020 would be $90,000.  

Assuming your effective tax rate is still the same, your income tax obligation for 2020 is now reduced to $22,500 ($90,000 x 0.25). This means you will be entitled to a tax refund of $2,500 ($25000 – $22,500).  

The refund could potentially be more since your marginal tax rate and therefore effective tax rate would likely reduce too. 

The tax refund of $2,500 can be put in your RRSP to offset tax obligations for the year 2021, or you may invest it in a Tax-Free Savings Account (TFSA) or other types of investments.  

I would have opted for a TFSA because my money can grow tax-free. And none of the growth will be taxed upon withdrawal now or upon retirement. Much unlike an RRSP where the contributions and growth are taxed upon withdrawal. 

And there’s the matter of a potential increase in taxes later after the dust settles and the government realizes the true impact of the Covid 19 pandemic on the country’s economy.  

Another drawback of an RRSP is that you must start withdrawing funds from your RRSP by age 71. The minimum withdrawal at 71 is 5.28% but it gradually grows to 10.21% at age 88, then tops out at 20% at age 95. If your income at age 71 is already high (a case with some pensioners with other forms of income), the forced minimum withdrawal could put you in a higher tax bracket which means your marginal tax rate becomes higher, thus you’re on the hook to pay more tax. 

The forced minimum withdrawal from your RRSP could also trigger the Old Age Security Pension (OAS) clawback (I will cover this in a future blog) so look ahead while you plan.   

Certainly, you should understand now why one of the questions I asked is: Do I plan to retire POOR? Because unless that is the plan, the tax benefit that I’m expecting to realize upon retirement is a delusion. 

Now that you are aware, be sure to make the wiser choice based on your situation. 

In the words of my retired principal: 

“No one explained how the RRSP works to us, or told us we would be forced to withdraw my own money! I contributed to it for the refund and used it to go on vacations. Now I’m paying a lot of tax because it increases my regular income! This RRSP is garbage and people should know!” 

Don’t get caught with your knickers down like my principal because you can’t say you didn’t know!!