The Taxing Truth About TFSAs, RRSPs and RRIFs

Himani Ediriweera
 

Crossroads
 

What is a TFSA? An RRSP? An RRIF?

A Tax-Free Savings Account (TFSA) allows Canadians age 18 and over to contribute up to $5,500 annually to a special account. Investment income from the account is tax-free, although contributions are not tax-deductible.

A Registered Retirement Savings Plan (RRSP) is a tax-deferred saving plan for retirement. Contributions to the plan are tax deductible up to a maximum amount. The amount accruing in the plan is not taxed. Withdrawals from the plan are taxed as income when withdrawn. When RRSP owners turn 71, they must convert the plan to a RRIF or be taxed on the entire amount.

A Registered Retirement Income Fund (RRIF) is a legal vehicle for disbursing funds that have been created in an RRSP. The money is tax-sheltered while in the fund, but taxed once withdrawn. RRIFs must be established before the owner turns 71 and cannot be added to once established. Regular withdrawals must be made according to a pre-arranged schedule.
 

Which ones work best and when?

Over the past few years, TFSAs have been gaining popularity over the much older, tax-deferred RRSP. While both are great tools for savings and share similar DNA, the one significant difference is that RRSPs are tax-deferred and TFSAs are tax-free. So the moment you make a withdrawal or start receiving payments from your RRSP or RRIF, you could take a tax hit.

If you’re the type of individual who can’t resist the temptation of raiding your savings, a TFSA is the best option for you. Always remember that an RRSP is tax-sheltered, not tax-free, and considered income.

  • If you have $100,000 in RRIFs, you are required to make minimum annual taxable withdrawals. Once taxed, that $100,000 could cost you $30,000.
  • If you have $100,000 in TFSAs, you’ll end up with at least $100,000 because mandatory yearly taxable withdrawals are not required and the money withdrawn is not taxed.
     

How are Canadians saving for retirement?

TFSAs are gaining momentum, but RRSPs currently have a slight edge. An RBC study in late 2014 reported that 54% of Canadians hold investments in TFSAs and 59% in RRSPs. A Bank of Montreal study found that 20% of Canadians plan to contribute the maximum amount to a TFSA. In addition, Canadians hold an average of $17,490 in TFSAs with more than half using the flexible, tax-free savings to plan for retirement.
 

So, are RRSPs still relevant?

Yes. An RRSP provides significant tax-deductible savings as you invest in your retirement. Contributions lower your taxable income and allow you to save more while paying fewer taxes. The sooner you start contributing, the more compounding, or interest, you earn on those savings. But at some point, you’ll have to pay taxes on the money you withdraw.
 

Which one is more flexible?

TFSAs are more flexible than an RRSP for three reasons.

First, the money you take out of a TFSA will not be taxed as income. This means that if you run into an emergency or want to take that luxury vacation, you’re better off using the funds in your TFSA.

In contrast, money taken out of an RRSP is taxed as income. The withdrawal amount is added to your annual earnings, which could put you in a higher tax bracket.

Second, TFSA contribution room is cumulative, and unused amounts can be carried forward indefinitely. Money taken out of a TSFA can be re-deposited later, up to your contribution room, without any penalties.

In contrast, if you raid funds from your RRSP before maturity, you will be assessed a withholding tax on those funds of 10% to 30% (depending on your province or territory). And you’ll lose tax-sheltered compounding investment room that can never be recovered.

Third, TFSAs have no age limit. You can continue to deposit funds into and use money from your TSFA as long as you want. The total contribution room to date is $36,500. Under proposed legislation, Canadian residents will be able to contribute up to $10,000 annually, up from the current amount of $5,500.

In contrast, you can contribute to your RRSP only until the year you turn 71.
 

What happens to my RRSP or TFSA when I turn 71?

By December 31 of the year you turn 71, you must select an RRSP maturity option, like a RRIF, and transfer your funds. RRIFs hold most of the same investments as an RRSP and allow for tax-deferred growth. Depending on the amount in your RRIF, it could provide you with income throughout retirement.

Once you convert your RRSPs to a RRIF, you are no longer able to make contributions to it.  As well, predetermined annual withdrawals, in increasing increments, are mandatory. Your balance continues to grow, tax-sheltered until it’s withdrawn. Once withdrawn, funds from a RRIF become taxable income. Any funds withdrawn in addition to your minimum is subject to a 10% to 30% withholding tax.

TFSAs have no age limit. You can continue to contribute to them, tax free, even after turning 71.
 

So, to recap, what are the differences between TFSAs, RRSPs and RRIFs?

Both TFSAs and RRSPs offer tax-sheltered growth.

  • Savings in a TFSA are tax-free, while savings in an RRSP/RRIF are tax-deferred.
  • Investments within a TFSA can be withdrawn, tax-free, anytime. Early RRSP/RRIF withdrawals result in a withholding tax of 10% to 30%.
  • Funds withdrawn from a TFSA are automatically added to your TFSA contribution room for the following year. RRSP contribution room depends on your taxable income, up to a maximum.
  • TFSA contributions are not tax-deductible. RRSPs reduce your taxable income and increase your income when withdrawn.
  • There is no lifetime contribution ceiling on a TFSA and you are not required to have earned income to contribute.
 

RRSP

TFSA

RRIF

Deposits are tax-deductible*

Yes

No

n/a

Withdrawals are taxed

Yes

No

Yes

Plans can be added to*

Yes

Yes

No

Must earn income to contribute

Yes

No

n/a

Plans must be converted to an RRIF when the owner turns 71

Yes

No

n/a

* Up to a maximum amount

Depending on your savings goals, both TFSAs and RRSPs are great savings tools. Experts recommend having, both but if this isn’t possible, speak with a financial advisor who will help you determine the best plan suitable for your needs.