The tax-free savings account (TFSA) and registered retirement savings plan (RRSP) are two of the most popular investment accounts in Canada. The former lets you deposit, invest, and withdraw funds all tax-free. The latter lets you deposit funds, receive a tax deduction for the deposit, and then compound your investments tax-free until your withdrawal date, at which point the funds become taxable. Both of these accounts have the potential to save you considerable money on investments. However, they are far from identical.
Basically, the TFSA is more flexible than the RRSP, allowing you to cash out your gains whenever you wish. If you make a big investment gain and want to use the funds to buy your dream car, then you’re better off having the investments in a TFSA. If, on the other hand, you are saving for a retirement that you see happening in 30 or 40 years, then the RRSP may be more appropriate. In addition to offering a tax break on contributions, the RRSP also typically has higher annual contribution limits than the TFSA does, making it an excellent vehicle for the diligent Canadian retirement saver.
In this article, I’ll explore the one rule separating TFSAs from RRSPs that most Canadians forget to their detriment.
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Mandatory withdrawals
By far the biggest difference between TFSAs and RRSPs that most Canadians forget is the fact that the RRSP has mandatory withdrawals. When you turn 71 years old, you have to convert your RRSP into a registered retirement income fund (RRIF) and start drawing down the amounts that you have in the account. If you start withdrawing between the ages of 70 and 74, you have to withdraw 7.4% per year. By the time you’re 95 or older, you have to withdraw 8% of your money each and every year!
This is something about RRSPs that most Canadians aren’t aware of. While everybody knows that RRSP withdrawals come with a tax penalty, not everybody knows that such withdrawals become mandatory at some point. So if your plan is to keep every penny in your RRSP until you pass in your eighties and then give it all to your kids, that might not work – by age 71, you need to start withdrawing the funds.
How to handle this rule
If you’re nearing retirement age, you might be wondering how to handle your RRSP and TFSA differently, given the former’s strict rules and the latter’s smaller contribution limits. There are a few rules of thumb you can follow.
First, if you plan to cash out of investments relatively soon, or conversely hold them for life, the TFSA beats the RRSP. You neither have to withdraw nor hold for life in a TFSA; the choice is yours.
Second, if you’re investing for retirement expenses, the RRSP may be the way to go.
RRSPs are the perfect accounts in which to hold investments to fund your retirement. If you put a portfolio of low-cost index ETFs into an RRSP and keep the money there until age 71, you should end up with princely sums of money coming in in your old age.
As an example, we can consider the Vanguard FTSE Canada ETF (TSX: VCE). This is an ultra-cheap, highly diversified ETF built on the FTSE Canada stock market index. It has a rock bottom 0.06% management fee – among the lowest of all Canadian funds. It has 84 stocks, which is a decent amount of diversification. Its portfolio has a 19 P/E ratio, far lower than the North American market averages. Finally, VCE is 100% Canadian, so you pay no withholding taxes on the holdings. Definitely a fund worth considering for your RRSP.
