There are several registered accounts where Canadians can hold their equity investments. Two of the most popular registered accounts in Canada include the Tax-Free Savings Account or TFSA and the Registered Retirement Savings Plan or RRSP.
Both the accounts allow Canadians to hold equity investments, making them attractive for stock market investors. One of the most popular financial instruments in the stock market is dividend stocks as they allow investors to create a passive income stream as well as build wealth via long-term capital gains.
Here, we take a look to see which between TFSA and RRSP is a better account for you to hold dividend stocks. The two accounts offer tax incentives to Canadians and provide you an opportunity to grow your capital by investing in a variety of asset classes.
Alternatively, there are also some key differences between the accounts making them suitable for a particular set of investment goals.
Tax-Free Savings Account
The TFSA program was introduced in 2009 as a way for Canadian residents above the age of 18 with a valid social insurance number to keep money aside on a tax-free basis throughout their lifetime. Any contributions towards your TFSA are not tax-deductible for income tax purposes but any amount contributed as well as income generated in the account is exempt from taxes. These returns can be in the form of interests, dividends, or even capital gains.
Newbie investors might be misled by the name “Savings Account”. However, the TFSA operates similar to an investment account as you can buy stocks, bonds, ETFs, mutual funds, and several other instruments.
There are no withdrawal rules associated with a TFSA and you can liquidate your investments at any time. However, there are certain contribution limits when it comes to deploying capital in this registered account. For example, the TFSA contribution limit in 2021 is $6,000 and this might vary each year.
Registered Retirement Savings Plan
An RRSP is a retirement savings plan that you can establish and start contributing towards once you are employed. The contributions towards the RRSP are tax-deductible which will reduce the overall tax bill. Any income earned in this registered account is exempt from tax until the funds remain in the plan. You will have to pay a tax on withdrawals when you receive payments from the RRSP.
The RRSP is basically a tax-advantaged account while the TFSA is a tax-sheltered account. The RRSP was created with the intention to provide Canadians with a tax break and encourage people to save for their retirement.
There are contribution limits for RRSP account holders as well. This limit begins to accumulate from the time you are employed so it also takes into account unused contributions from prior years.
For 2021, the RRSP contribution limit stands at 18% of your income or $27,830 whichever is less. So, in case you earn $100,000 annually you can contribute $18,000 towards the RRSP.
TFSA or RRSP: Where do you invest?
Now that we have looked at the necessary differences between the TFSA and RRSP, let’s see which registered account should be used to buy dividend stocks. Both the accounts are ideal for holding equity investments including dividend stocks and you need to consider your spending habits, earnings potential, investment goals as well as income levels before you make a buying decision.
Ideally, you would like to maximize your RRSP and TFSA contributions but this is not a luxury for most Canadians. According to a report from Wealthsimple, in case you earn over $50,000 a year you should prioritize investing in the RRSP and vice versa.
When you contribute towards your RRSP, you are able to deduct these contributions, allowing you a tax refund based on your marginal tax rate for the year. Now, during retirement you will be part of a lower tax bracket as your earning capacity will be reduced.
So, when you withdraw money from the RRSP you will be taxed at a lower rate. In a nutshell, you should aim to contribute towards your RRSP when you earn a higher income and withdraw it during low-income periods such as retirement or unemployment, thereby leveraging these tax benefits.
For example, in case Jessica earns $100,000 a year, the marginal tax rate will be close to 40%. Comparatively, if she earns $40,000 in her retirement her marginal tax will be significantly lower. So, the RRSP contributions are able to grow with pre-tax savings and she will be allowed to keep a higher portion of these savings in retirement.
The RRSP is also a good account for long-term investors or for those looking to invest in foreign equities. The Internal Revenue Service south of the border does not accept the TFSA as a retirement account and you will have to pay non-resident withholding taxes on income generated from these investments.
According to financial planners, in case you are part of a lower income bracket (say less than $50,000), it is advisable to first maximize your TFSA contribution limit as it isn’t linked to your income. Lower-income earners will also have a lesser marginal tax rate and they can use the unused RRSP contribution room in the future when their income levels rise.
Buying dividend stocks in a TFSA also makes sense if you want to withdraw money in the future once you have hit your financial goals such as saving for a vacation or even your wedding.
The final takeaway
We have seen that both the RRSP and TFSA carry certain benefits and the two registered accounts should be part of your investment strategy. However, in case you are saving for the long-term and earn over $50,000/year you need to prioritize RRSP contributions and hold dividend stocks here. Alternatively, the TFSA contributions can be accessed at any time making it a better account for financial emergencies and people in a lower income group.