Each year, as the contribution deadline for registered retirement savings plans (RRSPs) appears on the horizon, Michael Sottile finds himself answering variations of the same question over and over again.
In fact, it's one of the most common question the TD Financial Advisor gets from his clients: "Should I invest my money in an RRSP, or a tax-free savings account (TFSA)?"
This year was a little different. Because of the COVID-19 pandemic, Sottile said many of his clients have been spending more time thinking about ways to improve their financial health, and are asking more questions, well before RRSP contributions tend to be top of mind for Canadians.
If you're asking the same question yourself, Sottile shares some of the advice he provides to clients who are deciding between investing their money in an RRSP or a TFSA:
What are the differences between an RRSP and a TFSA?
An RRSP is a tax-advantaged savings vehicle designed to help you save money for retirement. Your RRSP contribution limit is based on your income, and the contributions you make are tax-deductible, which means you will not be taxed on the money you put into an RRSP until you withdraw it.
"RRSPs are primarily designed for long-term saving," Sottile said.
The product is primarily designed to help Canadians save for retirement, but funds can be accessed earlier in some situations, like through the Home Buyers' Plan or the Lifelong Learning Plan, subject to eligibility and conditions.
"While you may withdraw all or part of the money at any time, RRSP withdrawals are subject to tax and the terms of the investments you choose."
A TFSA is also a tax-advantaged savings plan and is designed to help you save money for any goal – including big ticket items such as a new home or a vehicle, travel, or a wedding.
The amount of money you're allowed to contribute to a TFSA isn't based on your income, but rather is dictated by an annual limit set by the federal government. However, unlike an RRSP, your contributions are not tax-deductible. Keep in mind that if you contribute more than your contribution limit, you will pay a penalty of 1% per month on the excess amount.
What am I saving for?
Sottile likes to tell his clients that understanding what you are trying to achieve is important when you're choosing a savings method, whether it's an RRSP, a TFSA, a combination of the two, or another kind of savings program.
"While RRSPs are typically used by clients who are trying to save for retirement, there are also several programs that permit RRSP withdrawals for certain purposes," Sottile said.
For example, you are allowed to withdraw up to $35,000 from your RRSP if you are purchasing your first home under the Home Buyers' Plan, or withdraw up to $20,000 from your RRSP if you need to use that money to go back to school under the Lifelong Learning Plan.
With a TFSA, you're not taxed on the income you earn. Withdrawals are tax free, and the withdrawn amount is added back to your contribution room at the start of the following year. So it's a great way to save for short or long-term goals because it lets your savings grow tax free.
Any withdrawals from an RRSP, outside of certain exceptions, are subject to withholding tax that varies depending on the amount withdrawn and residency of the client.
What's my timeline for reaching my savings goals?
It's important to consider a client's financial situation before making a recommendation of a TFSA or an RRSP, Sottile said.
"If a client is looking to purchase their first house or are saving for retirement and have another 10 years before that or more, then an RRSP may be more beneficial because contributions help reduce your taxable income, which may help you save faster."
The key difference between the two is the timing of taxes, Sottile said.
"TFSA contributions are not tax-deductible while RRSP contributions are and may help reduce a tax bill or generate a refund," he said.
"Depending on your individual circumstances such as your income, or if you are self-employed and are expecting a tax bill, an RRSP might be a better option for you. Overall, at TD, we recommend speaking with a financial advisor to ensure you receive advice tailored to your situation and goals, and being sure to revisit and review these plans during any major life change."
Do I need to invest in a TFSA or RRSP, or can I choose something different?
Of course, the decision to invest your money in a TFSA or an RRSP is not a binary choice. Choosing from the variety of savings and investment products available depends on your financial aspirations both now and in the future.
There are many other investment options that could benefit you, depending on your risk appetite and investment goals, Sottile said.
The best thing you can do is book an appointment with a financial advisor and have them help you come up with a plan that helps you achieve your financial goals, Sottile said.