RRSP-TFSA concepts & coordination

Your decision depends on many factors

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for improving our finances. However, when it comes to retirement savings, the RRSP should be the default choice for most of us.

Here are some important considerations to help you decide what’s best for you.

Tax treatment IN – Tax treatment OUT

The key difference between these plans is what happens on front and back end:

- RRSP deposits are pre-tax, income within is sheltered, and withdrawals are taxable
- TFSA deposits are after-tax, income within is sheltered, but withdrawals are not taxed

If you’re depositing to an individual RRSP, any associated refund must also go into your RRSP to keep it intact as ‘pre-tax’. For workplace group RRSPs, your employer does this for you through withholding tax.

Base comparison

If your income is taxed at the same rate when contributing to and withdrawing from the investment, your spendable cash will be the same either way.

Using $100 at a 40% tax rate and a 10% return (to allow for simple arithmetic):

However, if the withdrawal tax rate is reduced to 30%, the tax on the $110 in the RRSP will be reduced from $44 to $33, netting $77. On the other hand, if the withdrawal tax rate is 50%, the tax will be $55, netting to $55.

So, if you expect your tax rate to be lower when you will be taking withdrawals from this investment, choose RRSP. But if you expect a higher rate later on, choose TFSA.

‘Same rate’ – Marginal or average?

To assist in comparing rates, keep in mind we have a progressive tax system. That means higher income is taxed at a higher rate. An RRSP contribution gives you a tax deduction at your top marginal tax rate.

On withdrawal in your later years, the appropriate comparison is average rate, which is total tax divided by income. As average rate is mathematically lower than marginal rate, RRSP is usually the default choice.

What’s your own expected average rate?

In truth, your RRSP (in the form of a RRIF or annuity draw) will not be your only retirement income. You will have Canada Pension Plan and Old Age Security, and may have a pension, all together forming your foundation income. Thus, the average rate on your RRIF/annuity will be higher than your overall average.

And if you expect your retirement income to exceed the OAS clawback level, that will raise your effective marginal tax rate – that’s when it’s time to run the numbers through a financial planning spreadsheet!

Default choice, but with flexibility

To repeat, the point here is that RRSP is the default choice, but it could be displaced. Think of it in terms of proportionally allocating savings between them, not an either-or decision. Consider these factors:

Favouring RRSP

Most people live on a lower income in retirement. Spousal pension income splitting can reduce seniors’ household tax rate. The pension credit can reduce tax on $2,000 of RRIF/annuity income.

Favouring TFSA

Savings timeframe is shorter term, not retirement. Contributor is at low bracket at saving age. There are already significant RRSP assets. A large inheritance/winfall is confidently expected

TFSA – Tax-free savings account

Added flexibility for your tax-sheltered savings

The TFSA is a flexible savings plan that can be used – and re-used – for any savings purpose over a person’s lifetime. Qualified investments include deposits, guaranteed investment certificates, stocks, bonds, mutual funds and segregated funds.

Compared to other registered plans, the TFSA has relatively few rules to understand and follow.

Key tax features

Whereas RRSP contributions are deductible in the year made, and withdrawals are eventually taxable, for TFSAs:

- Contributions are after-tax, meaning they are NOT deductible in calculating income
- Income in the plan is tax-sheltered, unlike RRSPs for which income is tax-deferred until withdrawn
- Withdrawals are NOT taxed no matter when taken, and do not affect income-tested public support payments

Who can invest money in a TFSA?

To contribute to a TFSA, you must be a Canadian resident who is at least 18 years old and has a Social Insurance Number (SIN). Even foreign citizens who are resident in Canada qualify, though their home country rules may subject a TFSA to tax. If the age of majority to enter a contract is 19 in your province, the allotted TFSA room for age 18 carries forward to be used in a future year.

Unlike RRSPs which prohibit contributions after age 71, there is no upper age limit for TFSAs.

No tax applies if you become a non-resident of Canada, but you may not make contributions while a non-resident, nor are you credited with annual room. A 1% per-month penalty tax applies to non-resident contributions.

Contributions and withdrawals

From age 18, every Canadian resident is entitled to an allotment of annual TFSA room, which began at $5,000 in 2009. Other than 2015 when the annual room jumped to $10,000 (an election year goodie), that annual room is indexed in a way that rounds to the nearest $500 every few years, and currently stands at $7,000 for 2024. Unused room carries forward for use in any future year. For someone who has been eligible since the TFSA became available in 2009 but has not made any contributions, the cumulative room is $95,000 in 2024.

If you exceed your limit, there is a 1% penalty tax on your highest excess amount each month.

In addition to cash contributions, you may transfer securities in-kind to a TFSA, but the transaction may trigger tax. From a non-registered account, there is a deemed disposition at fair market value (FMV) that may result in a taxable capital gain, or if it comes from your RRSP it will be a taxable withdrawal at FMV.

If you borrow to contribute, the Income Tax Act (ITA) does not allow a deduction for the loan interest. This principle is based on the fact that the corresponding TFSA income is not taxable.

Credit for re-contribution

When you withdraw money from a TFSA, you receive a dollar-for-dollar re-contribution credit. This allows you to build savings and use them for a current need, and use that same room again in future. Be aware though that the credit is effective January 1st of the following year. If you plan to re-contribute sooner than that, make sure you have sufficient room separate from this credit, or you could be exposed to that over-contribution penalty.

Lifetime gifts and transfers

Generally, if you make a gift to a spouse/common-law partner (CLP) for investing, the ITA income attribution rules cause you the giver to be taxed on any resulting investment income. However, those attribution rules do not apply if the recipient spouse/CLP places that gift into a TFSA.

In fact, you can give money to anyone to contribute into their own TFSA, without any attribution concern. However, once money is in a TFSA, it cannot normally be transferred as a TFSA directly from one person to another.

But there is an exception that does allow for the transfer of a TFSA in the case of a spouse/CLP relationship breakdown. In that situation, the recipient spouse/CLP receives the transferred TFSA (which continues to be treated as a TFSA) and his/her existing contribution room remains as is. Unfortunately for the transferor spouse, the transaction does not result in a re-contribution credit.

Estate planning

Upon death, your TFSA will fall into your estate to be distributed among your estate beneficiaries. Alternatively, similar to other registered plans, you may designate one or more beneficiaries on your TFSA contract. (Note for Quebec residents that the law does not allow beneficiary designations on plans in that province.)

Money paid out through a TFSA beneficiary designation is tax-free to recipients, but the money is no longer in the form of a TFSA (except for a spouse/CLP, as discussed below). Those beneficiaries may use that money for whatever purpose they wish, including contributing to their own TFSAs to the extent of their available room.

Planning for spouse/common-law partner

There are additional options and benefits if you wish to leave your TFSA to your spouse/CLP. You can name him/her as “successor holder” of the TFSA upon your death, which can be recorded on the TFSA contract or be stated in your Will. This applies to the entire plan, and therefore cannot be mixed with a beneficiary designation. The plan will then continue on with your spouse/CLP as the new annuitant (the owner) and, as with a transfer on separation, his/her existing contribution room is unaffected.

The same result can be achieved if your spouse/CLP is named as a designated beneficiary on the TFSA contract (sole or along with others) or is a beneficiary of your estate, though more steps are involved (ie., joint tax elections with the estate). As well, if the TFSA flows through the estate then probate fee/tax may apply to the value of the plan in some provinces. Even so, in more complex estates such as second marriages or mixed families, it may be necessary to use one of these other options where contingencies need to be built into the estate planning.

Whatever option may be chosen, it is important to understand that unused TFSA room cannot be transferred to anyone, even a spouse/CLP. In effect, it dies with the person. That should be considered by a couple in deciding how to draw down their savings, especially in more advanced years or when managing with a terminal medical condition.

FHSA – First home savings account

The newest way to build a down payment for a new home

Housing cost is one of the largest budgeting outlays for the average family. For those looking to make the move from being renters to owners, it can be challenging to both cover current shelter needs and save toward a down payment on a first home.

First proposed in the 2022 Federal Budget and brought into effect in 2023, the First Home Savings Account (FHSA) entitles eligible taxpayers to:

- Tax-deductible contributions,
- Tax-free investment growth, and
- Tax-free withdrawals for a first home purchase.

Eligibility

The FHSA is open to Canadian residents age 18 to 71. To open an account, an individual cannot be living in a home owned by that person (solely or jointly) in the year the account is opened, or in any of the four preceding calendar years. This includes a home owned by a spouse or common law partner (CLP).

No tax will apply on FHSA withdrawals used for the purchase of a new home, but only one property will qualify for this special treatment over an individual’s lifetime.

Contribution treatment and dollar limits

Tax treatment

Like a registered retirement savings plan (RRSP), FHSA contributions are tax-deductible. Alternatively, an individual may choose to transfer existing RRSP funds to a FHSA on a tax-free rollover basis, though such a transfer will not restore RRSP contribution room.

Dollar limits

The lifetime contribution limit is $40,000, subject to a base annual FHSA participation room of $8,000. Both new contributions and existing RRSP transfers count toward both the annual limit and lifetime limit.

A limited carryforward rule allows unused room to be added to a later year’s FHSA participation room. In the year that a person opens their first FHSA, their FHSA participation room that year is $8,000. In following years, the FHSA carryforward is $8,000 less all contributions and transfers made to all FHSAs in the prior year. That means that up to $16,000 could be contributed in a given year (other than the year the first FHSA is opened), though that would be the result of having made no contributions in the immediately preceding year.

An individual is allowed to open as many FHSAs as desired, but the annual and lifetime limits apply to transfers and contributions across all accounts. For someone who begins contributing the maximum $8,000 annual amount as soon as their first FHSA is opened, the lifetime $40,000 limit could be reached in five years.

Timing of deductions

Despite the similarities to RRSPs, there are important distinctions as to when deductions may be claimed:

- Whereas RRSP contributions in the first 60 days of a year may be deducted against the previous year’s income, FHSA contributions are deductible in the calendar year when made.
- Still, like RRSP contributions, if the person does not wish to take the deduction presently, it may be carried forward to use in any future year.
- Once there has been a qualifying withdrawal for a new home purchase, no further FHSA contributions may be made (and accordingly no new deductions allowed), but past deductions may still be used or carried forward.

Tax-sheltering investment income

Like many other registered accounts, including RRSPs and tax-free saving accounts (TFSAs), investment income and growth while within a FHSA are not taxable.

Withdrawals

Withdrawals to assist in the purchase of a first home are non-taxable, as long as you are not living in a home as your principal residence that year or in the preceding four years. Note that, unlike the criteria for opening a FHSA, you may be living in a home owned by a spouse or common law partner and still qualify for the tax-free withdrawal – understanding that the withdrawn amount must then be applied to a new home purchase. As well, both spouse/CLPs may use their FHSAs on the same purchase, if both meet the withdrawal criteria.

Tax will apply on FHSA withdrawals taken for any purpose other than a home purchase. However, this can be deferred by transferring into a RRSP, or to a registered retirement income fund (RRIF). Such transfers will not replenish FHSA room, but also will not require or reduce an individual’s RRSP room. Eventual withdrawals from the RRSP or RRIF will be taxable in the normal course.

Coordination with the RRSP home buyers’ plan

The RRSP home buyers’ plan (HBP) allows individuals to take up to $35,000 from a RRSP without tax applying in the year of withdrawal. Beginning in the second year following the first HBP withdrawal, withdrawn amounts must be returned to a RRSP over the course of up to 15 years. Repayments are not deductible, while any unrepaid amount is taxable in the year it is due.

As originally proposed in 2022, an individual was not permitted to use both the HBP and FHSA for the purchase of the same qualifying home. This restriction was removed by the time the rules came into force in 2023.

Plan closure

All FHSAs must be closed by December 31 of the earliest of:

- the year following the first qualifying withdrawal for a first home purchase,
- the 15^th anniversary of the first FHSA opening, and
- the year the individual turns age 71.

Amounts remaining in any FHSAs at the end of the defined period will be treated as income for that year.

Treatment at death

A detailed discussion of FHSAs at death is beyond the scope of this summary article, as there are many variables that can come into play. In general, any remaining account value will be treated as income of the estate, unless directed otherwise in the FHSA contract or in the deceased’s Will:

- If a spouse or common law partner is named as either successor holder or beneficiary, options may include receiving the amount as a taxable distribution, or transferring tax-deferred to the survivor’s own FHSA (if the survivor meets the qualifying criteria at that time), RRSP or RRIF.
- For any other named beneficiary, any amount received will be taxable income to the beneficiary in the year received. Not that this distinguishes FHSAs from RRSP/RRIF where the named beneficiary is entitled to the gross proceeds, but the amount is treated as taxable income in the deceased’s final year.