The Tax-Free Savings Accounts (TFSA) and the Registered Retirement Savings Plan (RRSP) are the widely used investment accounts in Canada. Each one has unique characteristics, although the objective is the same. You can use either to build wealth or secure your financial future.
Both accounts are tax shelters on investment returns. The TFSA is tax-free, such that there are no taxes whatsoever on earnings, gains, or interest when you withdraw. In contrast, the RRSP is a tax-deferred account where there is tax-free money growth, but you will pay taxes when you withdraw.
However, utilization can be perfect if users of these investment vehicles can avoid two common mistakes.
Using the TFSA and RRSP as savings account
The term savings is deceiving because the TFSA and RRSP are far from being savings accounts. You can save or hoard cash in either, but you limit the earnings potential or get none at all if you do.
It would defeat the purpose of using your TFSA and RRSP as simple savings accounts and withdrawing money when you need it. The primary goal when you open either account is for long-term retirement savings.
Rules are governing the management of the TFSA and RRSP. The shared one is a direct contribution with set limits. You pay penalty tax when you overcontribute to the accounts.
For the TFSA, the annual maximum limit changes from year to year. The contribution for the TFSA in 2020 is $6,000, while the cumulative lifetime maximum is $69,500. But for your RRSP, you can contribute 18% of your previous year’s earned income to $27,230, or whatever is lower.
The penalty tax for overcontribution is 1% of the excess contribution per month. Your remedy is to withdraw the excess so as not to pay an unnecessary penalty. There is a $2,000 grace amount for overcontribution in the RRSP, but the TFSA offers none.
You can choose your investments, whether you’re a TFSA or RRSP user. Your investments can be in bonds, ETFs, GICs, mutual funds, and stocks.
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TFSA and RRSP are practical investment tools. Use them well, and you will see how fast your money can grow.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Christopher Liew has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Enbridge.