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Taxation Incidence: RRSP and TFSA


Let’s compare the taxation incidence for the two most common registered accounts in Canada: Registered Retirement Savings Plans (RRSP) and Tax-Free Savings Accounts (TFSA). I would like to highlight the tax implications at time of deposit, gains/losses during lifetime of the plan and withdrawal. This article should give you a general idea of the key differences between the RRSP and TFSA when it comes to taxation treatment. Before we focus on taxation, let’s review contribution room limits, and important deadlines for both RRSP and TFSA.


RRSP contribution room is based on earned income. The amount of contribution room is the lesser of: 18% of earned income or the 2023* threshold of $29,210 (*the RRSP dollar limit is subject to yearly increase). Since RRSP contributions generate a tax deduction, the government of Canada allows contributions for a given tax year up to the first 60 days of the following year. If the deposit is made before that date or on that date, the credit can be applied to the current taxation year. In layman’s terms, if the year is 2023, an investor has until the first 60 days of 2024 to contribute to their RRSP. Personal RRSP contribution room accumulates year over year even if the maximum amount is not deposited by the investor.[1]


TFSA contributions are based on a pre-determined contribution amount. TFSAs were introduced in 2009. To open a TFSA, an investor must be a Canadian citizen with a valid SIN and attained age of 18. If an investor has never contributed to their TFSA, the 2023 maximum room accumulated would be $88,000. This amount increases regardless of previous year or current earned income. 2023’s increase in TFSA room is $6,500. TFSA’s do not generate a tax slip. Deposits and withdrawals occur on a tax-free basis. Contribution room (principal only) can be reclaimed upon withdrawal and is added back the following calendar year. We will highlight this in the withdrawal section.[2]

In the 3 bullet points to follow we will look at taxable incidence upon: deposit, gains/losses during the lifetime of each account, and withdrawal. I will include fictional examples to help us understand the tax implications of each scenario. It should be noted that this post should not be taken as direct tax or financial advice; this article is general in nature. Should anyone require additional planning, we suggest you contact us directly.


1. Upon Deposit


With any RRSP deposit, the tax savings is generated is based on personal Marginal Tax Rate (MTR). That means the amount you contribute will be considered a deduction. Furthermore, an investor’s personal taxes will vary depending on your previous year’s income. When a contribution is made to an RRSP, the amount will be deducted against earned income for the year. We will use an example below to illustrate these savings for the investor.

Kim Moneyman resided in British Columbia and earned $140,000 last year. Kim decides to contribute $10,000 to her RRSP. Based on her MTR of 40.70%, and RRSP contribution of $10,000 Kim can expect a tax savings of $4,070. Kim can claim the deduction on her current year taxation. This can be a great way to reduce earned income and generate tax savings. Now let’s look at TFSA contributions.

With the TFSA, this is the only account that allows for true tax-free deposits and withdrawals. Let’s say an investor has turned 18 on Jan 1st, 2023. They now have $6,500 worth of TFSA contribution room. The investor can contribute the maximum amount into their TFSA account. There is no tax deduction or credit available upon this deposit. This may have you wondering what is the benefit? To answer this, we will look at gains/losses during the lifetime of the account and withdrawal in the sections to follow.

Kim Moneyman decided this time to contribute $10,000 into her TFSA this year. Because there is no deduction to claim, no upfront tax relief will be realized. The tax benefits of the TFSA are realized during the lifetime of the account and upon withdrawal.


2. Gains/losses during the lifetime of the account


The similarity between RRSP and TFSA accounts is the tax-free gain/loss year over year of invested funds. In a non-registered account, gains/losses are accounted for and reported by the investor each year. With these two registered accounts, the next taxation incidence occurs upon withdrawal. Both accounts allow for the tax-free accumulation of gains (in any form) while funds remain invested, however the RRSP and TFSA differ when the investor withdraws funds from their accounts.

We can say that RRSP gains accrue on a ‘tax-deferred’ basis as there will be tax to be paid upon withdrawal; the TFSA gains accrue on a truly ‘tax-free’ basis as the withdrawals occur on a tax-free basis. In the last section we will discuss the differences between the taxation incidence on withdrawal. To illustrate both points we will again use our fictional client Kim to demonstrate.

Kim’s RRSP contribution of $10,000 has earned 5% this year and now sits at $10,500. There will be no realized tax incidence while the funds remain inside the RRSP. Conversely, if the account was to lose 5% and the value was $9,500, Kim cannot claim a loss on the account. If we look at her $10,000 deposit into her TFSA, while funds remain in the account, there will be no realized gain or loss on the year. In the final section we will explore the taxation incidence upon withdrawal.


3. Upon Withdrawal


Let us look at what happens with RRSP and TFSA when we withdraw funds from the accounts.

With RRSP withdrawals, there now is a taxable incidence. Any withdrawal from an RRSP is considered earned income and must be claimed in the year an investor withdraws. Despite the funds growing on a tax-deferred basis, the investor will generate a T4RSP slip on any withdrawal. They will need to include this amount in their tax return. As mentioned earlier it is important to keep the investor’s Marginal Tax Rate in mind. Let us see what happens when Kim withdraws RRSP funds when she retires at age 60.

Kim Moneyman is now retired and wants to begin withdrawing from her RRSP. She wants to withdraw $10,000 from her RRSP account. We will assume she is still residing in British Columbia and collecting a $70,000 pension and no other income. Her MTR is 28.20%. The $10,000 withdrawal will increase her earned income to $80,000 and generate taxes due for that year of $2,820. With the RRSPs, the benefit upon deposit is realized in the current taxation year; upon withdrawal, the taxes owing on RRSP withdrawal is considered earned income. Now let’s see what would happen if the withdrawal was a TFSA withdrawal.

With the TFSA account, the withdrawals are tax-free. This is regardless of gains/losses over the lifetime of the account. I will mention at this time as well, that upon withdrawal, the amount of principal invested in relation to the withdrawal will be added back to the total TFSA contribution room in the following year. To illustrate these two points, I will use an example below.

Let’s say Kim would like to further increase her available funds beyond the $80,000 she is currently getting from ‘earned income’ (pension and T4RSP). She looks to her TFSA to withdraw another $10,000 and is concerned about her tax liability. Fortunately for her, this withdrawal will be on a tax-free basis. The withdrawal will not incur any taxes. If $9,000 of this is considered principal and $1,000 as gains, Kim will also reclaim $9,000 of TFSA room in the following year. The main benefit of the TFSA is the ability for after-tax dollars to grow on a tax-free basis. When the funds are withdrawn, they are tax-free.


Summary


Both accounts allow some tax relief and do so in different ways. There is no right answer to the question: Which is more beneficial, the RRSP or TFSA? Depending on the investor’s situation, the answer to this question will vary. There are factors including but not limited to: timeline, earned income, marginal tax rate and timing of withdrawals.

What is important to note is the RRSP allows for an immediate upfront tax benefit to the investor. However, upon withdrawal, the amount received is considered earned income. The investor’s marginal tax rate will depend on overall earned income. In general, we expect the investor in retirement to have a lower MTR than in peak earning years. The RRSP can be considered a ‘tax-deferred’ account. Unlike the TFSA, which is a ‘tax-free’ account.

TFSAs do not get an upfront tax relief benefit. However, the gains accrued, and subsequent withdrawals are on a tax-free basis. The ability to reclaim contribution room upon withdrawal is another benefit of the TFSA. With the RRSP account, when funds are withdrawn from the RRSP, no contribution room can be reclaimed.

Each individual situation will determine whether we should prioritize either account. Sometimes both accounts may be utilized by the investor. To determine which is suitable for your potential situation, a full review should be completed. We hope this helps shed some light on the taxation incidence for each account.


Alexander Philipp, BA CFP



Refrences:


Alexander Philipp is attached to PEAK Securities Inc. as (Investment advisor). PEAK Securities Inc. is a full service broker registered with IIROC limiting its responsibilities to investment products such as stocks, bonds , ETFs and mutual funds. The information contained in this document has been prepared by Alexander Phillipp a registered investment advisor attached to PEAK Securities Inc. The information has been obtained from sources considered reliable and relevant. The information in this document is general in nature and may not be complete in regards to your personal situation. This document does not constitute investment advice. The opinions expressed above do not necessarily reflect those of PEAK Securities Inc. Peak Securities is not liable for the content of this document.


 
 
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