Understanding the difference between a TFSA and an RRSP

Canadians once had a reputation as savers, but we are now being out-saved by the Americans, according to economists at BMO Nesbitt Burns. Our personal savings rate has fallen to less than three percent. Canadians looking to buck that trend should consider appropriate tax shelters.

The Canada Tax Act says all investment income is considered taxable. This includes interest earned on savings in bank accounts or in savings bonds. So if you have any savings, you usually receive a T5 slip and include the income on your tax return.

But since 2009, Canadians 18 years of age or older can open a Tax-Free Savings Account (TFSA). The annual contribution limit is $5,000 but the interest or dividend earned is tax free.

In contrast, money invested in an RRSP is tax deductible, with the limits calculated based on annual income, as well as any carry-forward amounts. As a basic rule of thumb, for every $1,000 RRSP contribution, you receive about $300 in federal tax savings.

Contributions to TFSA are not tax deductible and it may take some time to see the savings. For example, the current interest rate on savings accounts is about 1.5 percent. If you deposit $5,000 on Jan 1, 2010, you will shelter about $75 of interest in the first year, or approximately $30 in tax savings. A TFSA also provides more flexibility for withdrawing money, as there is no penalty and you do not lose your contribution room.

However, a TFSA is not like a regular savings account. You can only deposit a total of $5,000 for the year, so making regular withdrawals and deposits may lead to over-contributions. If you deposit $4,000 and then withdraw $1,000 and then deposit $2,000 in one calendar year, you will be $1,000 over your contribution limit even though there is only $5,000 in the account. There are penalties for over-contributing.

Before you decide on a TFSA or RRSP, you should ask yourself a few questions.

• are you expecting your income to increase or decrease in the next year?
• are you able to contribute the maximum amount to your RRSP?
• are you planning to buy your first home and take advantage of the Home Buyers Plan?
• do you need easy access to your money in case of emergencies?

The answers to these questions alone will not decide which option is best for you, but they will contribute to your eventual decision.

It is best to assess your own personal situation and decide on the savings plan that works for you. RRSPs and TFSAs are two legal ways to shelter your hard-earned money, so understanding how they can work for you helps keep a few more dollars in your pocket.

If you have any questions about this article, ask the Tax Advisory at http://www.hrbtaxtalk.ca/submit-your-question/.

Cleo Hamel
Senior tax pro and national spokesperson