For most Canadians, saving money is an exercise in competing priorities. Every dollar can only be spent once. Mortgage payments or rent, groceries, an emergency fund, vacations, and everyday discretionary spending all compete with contributions to registered investment accounts. As the cost of living continues to rise, finding extra money to invest has become increasingly difficult.
When people do have money to invest, one question comes up repeatedly. Should it go into a Tax-Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP)? Like many questions in investing, the answer depends.
Everyone’s tax situation, income level, and financial goals are different. While there is no universal rule that works for every Canadian, there are a few guidelines I personally find helpful when deciding where new investments should go.
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Rule No. 1: Start with your tax bracket
The biggest difference between a TFSA and an RRSP is when you pay tax. TFSA contributions are made with after-tax dollars. In exchange, your investments grow tax-free and qualified withdrawals are also tax-free.
RRSP contributions work the opposite way. Contributions generally reduce your taxable income today, but withdrawals in retirement are taxed as ordinary income. That makes your current income an important consideration.
A recent university graduate working an entry-level job may already be in a relatively low tax bracket. In that case, the immediate tax deduction from an RRSP may not be worth very much, making the TFSA an attractive first choice.
A mid-career professional earning a much higher salary may receive a significantly larger tax deduction from RRSP contributions. For them, deferring tax until retirement could produce a much better overall outcome.
Rule No. 2: Think about what you’re investing in
The type of investment also matters. If your portfolio is heavily invested in U.S. dividend-paying stocks or U.S.-listed exchange-traded funds (ETFs), an RRSP generally has an advantage.
Because the Canada-U.S. tax treaty recognizes RRSPs as retirement accounts, qualifying U.S. dividends can generally be received without the 15% U.S. withholding tax that applies even in a TFSA.
Canadian dividend-paying stocks, Canadian ETFs, and most other domestic investments work very well inside a TFSA, where future capital gains, dividends, and interest can all be withdrawn tax-free.
Rule No. 3: Buying a home changes the equation
If buying your first home is one of your primary financial goals, I would generally prioritize the RRSP over the TFSA. The reason is the Home Buyers’ Plan. Under current rules, eligible Canadians can withdraw up to $60,000 from their RRSP tax-free to help buy or build a qualifying first home.
There is one important catch. The amount withdrawn must be repaid to your RRSP over 15 years, beginning in the second year after the withdrawal at 1/15 of the outstanding amount each year. Those repayments do not count as new RRSP contributions because they simply replace the money previously withdrawn under the Home Buyers’ Plan.
Used properly, the strategy gives first-time homebuyers access to their retirement savings without immediately triggering income tax, making the RRSP a particularly attractive option for those planning to purchase a home.
