Contributions reduce your taxable income, lowering the tax you pay so you can keep more in your pocket.
Your investments grow, tax-deferred, while in the RRSP.
Income-splitting can be achieved through a spousal RRSP which allows the higher income earning spouse to contribute to an RRSP in their spouse's name. These helps even out retirement income and lower your income taxes both now and in retirement.
RRSPs can be used for more than just retirement. Canadian government programs allow you to access funds in your RRSP to help you buy your first home or pursue further education.
Anyone who files an income tax return and has earned income can open and contribute to an RRSP. There are limits on how much you can contribute to an RRSP each year. You can contribute the lower of:
There are two programs you can use to take money out of an RRSP plan without incurring tax. They are the Home Buyers’ Plan (HBP) and the Lifelong Learning Plan (LLP).
RRSPs have been around a lot longer than their tax-free cousin. The RRSP was introduced in 1957 by the Liberal government of Prime Minister Louis St. Laurent. Fifty-one years later in 2008, the Conservative government of Prime Minister Stephen Harper rolled out the Tax-Free Savings Account.
There is no minimum age for starting an RRSP, but you do need to have an income. The very last day you’re allowed to contribute to your RRSP is December 31 of your seventy-first year. Meanwhile, you can’t open a TFSA until you’re at least 18 years old and there’s no upper age limit for contributing to the tax-free savings vehicle.
If you are not a member of a registered pension plan (RRP) or deferred profit sharing plan (DPSP) through your employer, the RRSP contribution limit for 2016 is 18% of your 2015 income up to a maximum of $25,370. So if you earned $45,000 last year, your contribution limit this year will be $8,100. The TFSA contribution limit this year for all Canadians over 18 years of age is $5,500, regardless of income. Also, any unused TFSA contribution room rolls over each year. In fact, an adult who was 18 when the savings tool was introduced in 2009, would have accumulated $46,500 in contribution room, as of 2016.
Contributions to RRSPs are made with before-tax money. In other words, you don’t pay income tax on RRSP contributions, which makes for a larger tax refund when you file your return. Alternately, TFSA contributions are made with after-tax money. This means you have already paid the income tax on any money put into your TFSA so it can’t help lower your tax burden like the RRSP.
As RRSP contributions are tax deductible, any withdrawals made from your RRSP are taxed in accordance with your income that year. Contributions to your TFSA have already been taxed, so any withdrawals you make are tax-free. This means that any growth you earned inside your RRSP is taxable but the growth earned inside your TFSA is, well, tax-free.
Both RRSPs and TFSAs allow you to carry forward unused contribution room. However, if you choose to withdraw funds from your RRSP, the contribution room is lost and you don’t get to replenish it later. On the other hand, if you take money out of a TFSA, the amount withdrawn will be added back to the next year’s contribution room.
The following are the three tax advantages to your RRSP Contribution:
You get immediate tax relief by deducting your RRSP contributions from your income each year. Effectively, your contributions are made with pre-tax dollars.
The money you make on your RRSP investments i.e. your interest or investment income is not taxed as long as it stays in the plan.
You'll pay tax on your RRSP savings when you withdraw them from the plan. That includes both your investment earnings and your contributions. But you have deferred this tax liability to the future when it’s possible that your marginal tax rate will be lower in retirement than it was during your contributing years
Following are the types of RRSP accounts and it can be set up with either one or two associated individuals:
The Tax-Free Savings Account (TFSA) program began in 2009. It is a way for individuals who are 18 and older and who have a valid social insurance number to set money aside tax-free throughout their lifetime. Contributions to a TFSA are not deductible for income tax purposes.
Any amount contributed as well as any income earned in the account (for example, investment income and capital gains) is generally tax-free, even when it is withdrawn. Administrative or other fees in relation to TFSA and any interest or money borrowed to contribute to a TFSA are not deductible.
The Tax-Free Savings Account has generated a lot of positive interest across Canada—and for good reason. Here are the special features that make a TFSA such a great savings option:
Unlike other registered tax-deferred plans, earnings throughout your lifetime from qualified investments in your Tax-Free Savings Account—whether interest, dividends or capital gains—are never subject to Canadian tax. You don’t pay taxes even when you withdraw your money.
You can withdraw funds from your TFSA whenever you want (depending on what you've invested in), and use the funds for multiple purposes. This makes a TFSA ideal for both your short and long-term investment goals. For example, you could save to purchase a new car, renovate your home, buy a new home, start a small business, take a vacation, build an emergency fund, etc.
You don’t need to have earned income to contribute to a TFSA. This is excellent news if you are retired or a stay-at-home parent. (Your spouse or common-law partner can give you funds to contribute to your own TFSA. There are no tax consequences to either you or your spouse.
With a Tax-Free Savings Account, unused contribution room is carried forward indefinitely, so you can contribute whenever you have the money. Withdrawals are also added to your unused contribution room starting the following year.
You can hold a wide range of investments in your TFSA, including Funds, GICs and Savings Deposits. You can also invest in stocks and bonds through Direct Investing and Dominion Securities. This makes the Tax-Free Savings Account appropriate for all types of investors.
There is no requirement to collapse your TFSA at a set age. You can keep it as long as you live. This makes it especially valuable as part of a long-term strategy that also includes RRSPs/RRIFs.
There is no lifetime limit on the amount of your TFSA contributions. If you are eligible, you will accumulate contribution room equal to the annual contribution limit for every year you are a resident of Canada.
Income earned and TFSA withdrawals are not included as income for tax purposes, which means that they will not affect your eligibility for Federal income–tested government benefits and credits such as Old Age Security (OAS) or the Goods and Services Tax (GST) credit.
TSFA contribution room is indexed for inflation and annual limits vary by year. If you don’t contribute the full amount each year, you can carry forward the unused amounts, based on the contribution limits for each year. Here are the annual contribution limits for each year since 2009:
You can put money in at any time, up to set limits. You can take money out at any time, without paying any tax.
If you contribute too much to your TFSA, you'll pay a penalty of 1% per month on the excess amount until you remove it. If you over-contribute deliberately, you'll pay a 100% tax on any gains or income you make on the excess amount.
Any gains or income you make from holding these investments in your TFSA will be taxed at 100%.
You'll pay 100% tax on any gains made by swapping investments between your TFSA and a registered or a non-registered account. This is to discourage people from using their TFSA to realize gains on investments that would otherwise be subject to tax.
The most obvious disadvantage of a TFSA is the lack of an immediate reduction of your taxable income. With an RRSP you at least get to claim it as an income deduction. With a TFSA you don’t get to do this. The advantage only comes in on the other end (tax-free withdrawals) so if you are looking to lower your taxable income, this isn’t the way to go.
The TFSA has a current annual contribution limit of $5500. However, if you have lots of income to potentially invest, you may find this rather restrictive. With an RRSP you can contribute potentially more (18% of your income) up to just shy of $25,000. And if you want to invest extra money in a non-registered plan there is no limit at all (although it will be taxable).
Majority of the time we do a transfer between multiple TFSAs, where we will be eating into our own annual contribution limit. To avoid this, we must do a direct transfer, where the bank (or whoever is your TFSA issuer) does the transfer for us. Only in this way can we avoid the accidental over-contribution scenario!
When the investments inside your TFSA do well, you make money. That capital gain is tax-free. However you can’t claim capital loss when you lose money inside the TFSA. That money is lost forever; you can’t claim it back by subtracting it from a (taxable) investment outside your TFSA.
While a TFSA is a great way to earn tax-free income, if you put that money in the wrong type of investments you could end up losing money over the long term. And if you like to make numerous trades you could be hit with lots of commission fees or transaction fees.