There are a variety of types of investment accounts that Canadians can use to hold investments, and all the acronyms and different rules can certainly get confusing. The table below shows a simple comparison of the common options available, with further discussion on each further below. At the bottom of this page there is also a sample spreadsheet that you can use to do a comparison for your specific circumstances. Paying down debt is an alternative to investing money, so although not investment accounts as such, two additional debt repayment options have also been included for comparison purposes.
| RRSP | TFSA | RESP | Paying down deductible debt | Paying down non-deductible debt | |
|---|---|---|---|---|---|
| Annual limit (2023) | 18% of income capped at $30,780 | $6,500 | $2,500 / child (for max grant) | varies | varies |
| Tax impact upon contribution | Deducted from income | No impact | No impact | No impact | No impact |
| Other costs/benefit upon contribution | Might have employer matching opportunity | Nil | $500 CESG grant / child / year | Nil | Nil |
| Tax impact during investment phase | Nil | Nil | Nil | Reduces tax deductions | Nil |
| Tax impact upon withdrawal | Taxed as income | No impact | Partially taxed in hands of beneficiaries (likely low marginal rate) | No impact | No impact |
Registered Retirement Savings Plans (RRSPs)
RRSPs have been an initiative of the Canadian government since 1957 to encourage people to save and invest privately to fund their cost of living and other expenses in retirement, as an alternative to private pension plans which are not offered by all employers. They are not true tax shelters, but they do allow for tax deferral on both the initial contributions and investment income earned between contribution and withdrawal. Annual contributions are limited to 18% of an individual’s prior year income (subject to a cap, and reduced for those contributing to a pension plan), although contribution room can be carried forward to future years if not fully utilized. The fundamental idea behind RRSPs is that one can contribute during peak earning years (receiving a tax credit equivalent to the contribution multiplied by the higher marginal tax rate), and withdraw during lower income years (e.g. retirement) at a lower marginal tax rate.
RRSPs are often touted as the best way to save for retirement, and it is true that they can offer a significant tax benefits for many Canadians but they do have some limitations. The main drawback is that withdrawals from an RRSP are subject to full income tax in the year the withdrawal is made, which primarily impacts individuals who expect to receive substantial income from additional sources in their retirement years. If your marginal tax rate in retirement is similar to that during the year of contribution, then the tax benefit is minimal. This can be an issue for high net worth individuals, and those planning on receiving taxable income from pensions, dividends or rental properties during retirement. If you pass away with a significant RRSP balance, your estate will be taxed as if you withdrew everything in your final tax year, likely pushing you into a very high marginal tax bracket (although there are some exceptions, such as transferring to a surviving spouse’s RRSP, but then they may have the same issue down the road). Another downside of RRSPs is that all investment returns are fully taxed as income when withdrawn, even if some of the returns are due to capital gains which would have otherwise been subject to a lower inclusion rate outside of the RRSP.
A key thing to remember about RRSPs is that the main tax benefit is derived from the difference between marginal tax rates in the contribution and withdrawal years. A strategic approach can be to maximize RRSP contributions in high income years and use alternative investment vehicles (or even withdraw RRSP funds) in lower income years. You can also consider spousal contributions (contributing to a spouse’s account if they are expected to be in a lower income bracket in future). If your employee offers a matching scheme then this can provide a significant boost to your savings and should generally be taken advantage of even when the tax benefit may be nominal.
RRSP accounts can be managed by your financial institution, or self-directed via most banks or discount brokers. If you are comfortable managing your own investments then self-directed accounts can allow for more efficient investments such as low-cost index funds, which can have a significant long-term impact on your savings.
Pros
- Allows for tax deferral from high income years to lower income years
- Tax deferral on investment earnings, allowing for increased compounding
- Employer matching schemes can boost savings rates
Cons
- Withdrawals subject to income tax
- Limited contribution room, especially for those already contributing to a pension plan
- Contributions permanently reduce the allowable room (i.e. withdrawals do not increase the contribution room)
Tax-Free Savings Accounts (TFSAs)
TFSAs are a relatively new registered investment vehicle introduced to Canadians in 2009. They are separate to RRSPs and have their own rules and limits. You can contribute to or withdraw from a TFSA at any time, without affecting income taxes. Every Canadian resident over the age of 18 gets an annual increase to their TFSA contribution limit, which for someone who has been eligible since 2009 would be a cumulative $88,000 in 2023.
Tax-Free Savings Accounts are not limited to bank deposits and could equally be called Tax-Free Investment Accounts, as they are an ideal vehicle for holding income-generating investments. Unlike RRSPs where investment returns will ultimately be taxed upon withdrawal, returns within a TFSA will never be taxed. The other key advantage of TFSAs is that your contribution room will be restored after you make a withdrawal (for the next year). This makes them suitable for shorter term savings goals, such as saving for a home.
Similar to RRSPs, TFSA accounts can be opened at most banks as well as discount brokers, and can be managed by the financial institution itself or self-managed.
Pros
- No tax impact upon withdrawal
- Contribution room grows each year, and is restored after making a withdrawal.
Cons
- No tax deduction in contribution year
Registered Education Savings Plans (RESPs)
Often an under-appreciated cousin of the more widely known RRSP and TFSA, RESPs are available for those with kids who want to help fund post-secondary education costs. They are treated similar to a TFSA with no tax deduction upon contribution, however they are taxed in the hands of the beneficiary when withdrawn (likely at a low marginal tax rate while they are a student). The contribution can be made by anybody, but the registered beneficiary must be a child under 18 years old.
The real benefit of this program however, is the Canada Education Savings Grant (CESG), in which the federal government co-contributes a bonus 20% of whatever you put in, up to $500 annually and $7,200 total per child. To maximize this benefit you need to contribute $2,500 of your own money per child each year, which you should try to do from an early age to benefit from maximum compounding. There is also an additional bonus CESG of up to $100/yr for low income families.
Pros
- $500/yr CESG co-contribution
- Tax deferred earnings, potentially no tax if student income is low enough at withdrawal.
Cons
- No tax deduction in contribution year
Paying Down Debt
When considering saving and investing money, one must also consider the opportunity cost of such an investment. Opportunity cost is an economic principle that refers to the alternative opportunities that you choose to give up in order to make an investment. For most of us who carry household debt, choosing to invest in a TFSA, RRSP or RESP comes at the expense of paying down (reducing) outstanding debts.
There are many different kinds of debt, and not all debt should be considered equal. There are many opinions on how much debt is too much, and I will leave further discussion on this to another article. The important thing to consider when comparing investment options is whether the debt is tax deductible or not, and what interest rate the debt carries both now and into the future (ideally a similar time horizon as the investment being considered).
From a tax perspective, paying down non-deductible debt (e.g. personal loans, mortgage on a principle residence) is equivalent to earning interest tax-free with zero investment risk. Paying down deductible debt, however (e.g. mortgage on an rental property), is like earning interest in a taxable account for which your benefit is reduced by your marginal tax rate. This is due to the tax deduction you would otherwise get from paying interest on a loan taken out for income-generating purposes. Both are good outcomes, but generally it is better to pay down non-deductible debts first.
The interest rate on the loans can also impact your decision whether to pay down debt. If you are paying 6% interest on a variable rate mortgage, that should be quite an attractive option to pay down aggressively, equivalent to investing in a no-risk savings account yielding the same interest rate. If you have a 2% fixed-term mortgage on an investment property however, your effective rate after tax deductions will be less than that, so you are likely better off putting the money into a high interest savings rate earning 4% and pocketing the difference in rates. Interest rates are always changing (particularly so in 2022), so this comparison should be revisited regularly and especially as fixed term mortgages come up for renewal.
When considering paying down debts it is always worth reviewing personal cash flow needs and emergency fund sources, as paying down too much on an inflexible loan could result in financial stress if money is needed for an emergency. Many banks also have penalties for over-paying on mortgages, so be sure to check your loan agreements.
Pros
- Risk-free alternative to savings accounts
- Can be effectively tax free for non-deductible debt
Cons
- If interest rates are low, you may have better opportunities elsewhere
Example comparison table
The following table shows an example of how you might compare the options for investment vehicles based on a set of assumptions. A nominal $1,000 has been used, which can be scaled up to the relevant contribution limits.
Note that this is only a tool, and there are other factors to consider in making investment decisions. A key difference here is that mortgage payments come out with a lower long-term return, however they are effectively risk free. The return assumed for other investment accounts is a reasonable estimate for a long term balanced portfolio, which does carry some market risk and future returns will vary dramatically from year to year.
| Assumptions | ||
| Current Marginal Tax Rate | 40% | Inc. federal + provincial income taxes |
| Current Marginal Tax Rate on growth/dividends | 20% | approximation based on blended investment types |
| Expected Marginal Tax Rate in Retirement | 30% | |
| Expected Long Term Return on Investments | 6.0% | long term avg expectations |
| Mortgage Interest Rate | 4.0% | long term avg expectations |
| Investment Period (yrs) | 20 |
| RESP | TFSA | RRSP | Taxable Account | Mortgage Payment | Mortgage Payment | |
| Principal Residence (non-deductible) | Investment Property (deductible) | |||||
| Investment amount | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 |
| Initial Tax Benefit/Cost (assuming reinvested) | 0 | 0 | 400 | 0 | 0 | 0 |
| Initial co-contribution benefit | 200 | 0 | 0 | 0 | 0 | 0 |
| Effective initial investment | 1,200 | 1,000 | 1,400 | 1,000 | 1,000 | 1,000 |
| Compounded returns over investment period | 2,649 | 2,207 | 3,090 | 2,207 | 1,191 | 1,191 |
| Ongoing taxes on returns | 0 | 0 | 0 | -441 | 0 | -476 |
| Ending Value | 3,849 | 3,207 | 4,490 | 2,766 | 2,191 | 1,715 |
| Tax on withdrawal | 0 | 0 | -1,347 | 0 | 0 | 0 |
| Net Ending Value | 3,849 | 3,207 | 3,143 | 2,766 | 2,191 | 1,715 |
| Rank | 1 | 2 | 3 | 4 | 5 | 6 |