It’s February in Canada and that means ice fishing and RRSP deadlines. We have until the end of February 2024 to make deposits into an RRSP and apply those deposits to our 2023 income.

With all the ads you’re likely seeing, RRSP contributions are likely top of mind. And you may also be wondering, should I be putting my savings into a TFSA instead? The answer to which one you should use isn’t something I’m going to cover here – it requires more information about your personal circumstances. But I can help clear up the confusion between RRSP’s and TFSA’s.

What is an RRSP? What is a TFSA?

Unlike what many people think, an RRSP or TFSA is not a type of investment. The labels RRSP and TFSA are simply labels given to certain types of investments that qualify for preferential tax treatment. Such investments could be almost anything – mutual funds, GIC’s, real estate funds, I suppose even a savings account could qualify. As long as the financial institution meets the government requirements, they can lable their investment as an RRSP or TFSA and then the investment enjoys the preferential tax treatment that comes with those ‘labels’.

Further, the very same investment can have an RRSP or TFSA version, and a non-RRSP or non-TFSA version. So you could find a mutual fund at say a bank, and in one version it’s not an RRSP, and in another, it is an RRSP. The RRSP version will have better tax treatment.

Similiarities between RRSP’s and TFSA’s…..and universal life insurance

Non-RRSP and non-TFSA investments are taxed in specific ways. While not actually true, the easiest way to see that is that each year, any interest earned is taxed. So if you invest in a mutual fund and earn $10,000 of interest, you’ll pay taxes on that $10K. Maybe that leaves you with $7000 after tax of interest. So next year, you have your initial investment plus another $7000 to earn interest.

RRSP’s and TFSA’s don’t pay tax on interest while the interest remains in the account. So like the previous example, if you earn $10,000 of interest inside a TFSA or RRSP, there’s no taxes paid on that $10k. So next year you have your original investment plus a full $10k to earn interest on. $3000 of interest in your bank account more, plus interest earned on that. Over time, that amount of potential taxes paid staying in your savings will have a huge impact – you’ll have more money in the end.

Universal life insurance is similiar in that investments in the investment portion of the policy also grow ‘tax deferred’; there’s no taxes paid on interest earned as long as the money stays inside the policy.

Differences between RRSP’s and TFSA’s

OK, so here’s the difference. With RRSP’s, your contributions or savings going INTO the RRSP are not taxed. When you withdraw funds in the future, those withdrawals are taxed.

TFSA’s are the opposite. Money you deposit going in is after tax – you paid tax on that money. Then when you withdraw, there are no taxes paid.

So, RRSP’s no taxes upfront, taxes when you withdraw. TFSA’s, taxes upfront, no taxes on withdrawal.

Universal life insurance policies that I mentioned above are a distant third in line, because both deposits and withdrawals are subject to tax. Only the middle portion, investments as they grow and earn interest, are not taxed.

So here’s an example. You earn $100 and pay $30 tax, leaving you with $70. You put $70 into your RRSP and that triggers a tax return of $30, which you could put into your RRSP as well. End result you earned $100 and put $100 into your RRSP.

With TFSA, you earn the same $100 and pay $30 tax leaving you with $70. $70 goes into your TFSA, and there’s no refund – just the $70 which is after tax.

Now fastforward until retirement. YOu withdraw that $100 from your RRSP and are going to pay $30 in tax, leaving you with $70. Summary: $100 into the RRSP, $70 out.

Conversely with the TFSA, you put in $70 now. THen when you retire and withdraw $100, there’s no taxes. So $70 in, $100 out.

Which is better? Well, that depends on growth patterns, your tax rates now and at retirement, and government benefits. It really requires a professional to figure it out. And the numbers can get large, so you really should consider getting professional advice on whether you should use a TFSA or RRSP.

By contrast, the universal life insurance policy is $70 in and $70 out – you pay taxes both on deposits, and any interest earned on deposits.

So, all of the above is a gross simplification and is basically wrong for any specific example :). However, the basic concepts are correct; RRSP’s are are not taxed upfront or in the middle, then taxed on withdrawals; TFSA’s are the opposite, taxed upfront, not in the middle and not taxed on withdrawals. Again, it will take a calculator to determine which one you should use (and universal life insurance is taxed both on deposits and interest on withdrawals, but not on growth while the funds are inside the policy).

Hopefully that clears things up on the differences and simiiliarites, even if we didn’t determine which one you should use!