Graphic overview of Canada income tax, RRSP, and TFSA

Diagrams: Everything, Taxable, RRSP, TFSA

This diagram shows the ways that money can flow in and out of one’s life and financial accounts. In particular, it shows how money flows between one’s taxable bank account, RRSP, and TFSA, and how the money is taxed in each case.

Jump to case: (a), (b), (c), (d), (e), (f), (g), (h), (i), (j), (k), (l)

Taxable account

(a) Taxable earned income

Typical earned income comes from employment.

(b) Taxable investment gains

For investments made within a taxable account, their gains subject to income taxes. The gains come from dividends, interest, and capital gains, but not return of capital.

Each type of gain is taxed differently. Eligible dividends are given an income tax credit, foreign withholding taxes on US dividends are given a credit, and capital gains are taxed at half the rate of other income. (These type distinctions are lost when investing in a registered account.)

(c) Taxable spending

Money in taxable accounts can be used to purchase any good or service.

Registered Retirement Savings Plan

Money within an RRSP is considered tax-deferred because no taxes are paid before or at contribution, but taxes are paid at withdrawal.

(d) RRSP before-tax contribution

Contributions to an RRSP can be made anytime before age 72 for any amount up to the contribution limit. The contribution limit decreases by the amount of each contribution. At the beginning of each year, the contribution room increases by either 18% of the previous year’s earned income or about $24000, whichever amount is less. This contribution room carries over year by year until it is used. (There are tax penalties for contributing beyond the limit.)

When contributing to an RRSP directly from the employer’s side, the money is exempt from withholding taxes. The contributed amounts are excluded from one’s taxable income.

(e) RRSP after-tax contribution

Contributing to an RRSP using after-tax money, the contributed amounts are excluded from one’s taxable income, and this typically results in a tax refund at the year-end tax return time.

This case (e) is just an alternate mechanism for case (d), and both are subjected to the same contribution room. It is numerically equivalent to case (d) after the tax return is processed, but there is a delay in getting one’s money back (and thus opportunity costs).

Money withdrawn under the HBP or LLP (see case (g)) must be repaid in annual installments. The payments are not deductible from the taxable income (because the withdrawals were not taxed), but they do not consume the contribution room either.

(f) RRSP growth

Investment gains in an RRSP account have no tax within the account. The distinction between the types of gains is lost (e.g. capital gains, return of capital, eligible dividends, and “other income”; but US foreign withholding taxes are waived).

(g) RRSP withdrawal

RRSP withdrawals are added to one’s taxable income in the current year, and are subjected to a withholding tax of up to 30%. (Unlike a TFSA, the RRSP contribution room is not re-added in this case.)

Under special cases, a limited amount of money can be withdrawn from an RRSP without it being added to taxable income. This is allowed under the Home Buyers’ Plan (HBP) for the purpose of buying a home and the Lifelong Learning Plan (LLP) to pay for one’s education. (See case (e) for details on repayment.)

(h) RRSP fees

Money within an RRSP can only be used to pay for account and trading fees. For other uses, the money must be withdrawn to the taxable domain first (see case (g)). Money spent on fees can be considered as contribution room that is lost forever. (If RRSP money could be directly spent on goods and services, then this would be a loophole that allows the use of before-tax money.)

Tax-Free Savings Account

Money within a TFSA is already taxed, so there are no taxes on further gains.

(i) TFSA contribution

Contributions to a TFSA can be made anytime for any amount up to the contribution limit. The contribution limit decreases by the amount of each contribution. (There are tax penalties for contributing beyond the limit.)

Starting in the year 2009, a resident who is at least 18 years old gains about $5000 of contribution room each calendar year. This contribution room carries over year by year until it is used. (The annual contribution room increase amount is indexed to inflation, and rose to $5500 in the year 2013.)

(j) TFSA growth

Investment gains in a TFSA account have no tax within the account. The distinction between the types of gains is lost (e.g. capital gains, return of capital, qualified dividends, and “other income”; US foreign withholding taxes are not waived unlike RRSP).

(k) TFSA withdrawal

Withdrawals from a TFSA are tax-free, and can be done at any time for any amount. The amount withdrawn is added as contribution room to the next calendar year. (For example, $700 withdrawn in mid-2012 will cause the contribution room to rise by $700 on January 1, 2013.)

(l) TFSA fees

Money within a TFSA can only be used to pay for account and trading fees. For other uses, the money must be withdrawn to the taxable domain first (see case (k)). Money spent on fees can be considered as contribution room that is lost forever. (Unlike an RRSP, there are no advantages if it were possible to directly spend TFSA money on goods and services; in fact, it would be a disadvantage because withdrawing the money will re-add the contribution room whereas directly spending the money won’t.)

Notes

This article is intended to cover the concepts and principles of how Canada’s income tax system interacts with RRSPs and TFSAs, but is not intended to provide precise, authoritative information on the details such as exact contribution limits, penalties, and edge cases. Furthermore for brevity, some of the laws or amounts that have changed over time have been omitted from the discussion. For more detailed information, search on the web to find resources at the Canada Revenue Agency and at major banks.
Though not shown in the diagram, it’s possible to go directly from income to expenses skipping personal accounts. For example, a company can pay for an employee’s moving costs directly. This is merely a shortcut of (a) + (c), and the amount paid for the expense is still added to one’s taxable income and subjected to tax.
Collectively, the RRSP and TFSA are also known as registered or tax-sheltered accounts. Taxable accounts are also known as non-registered accounts.
When an RRSP is converted to an RRIF, cases (f) and (g) stay the same but cases (d) and (e) are eliminated. Case (h) gets the additional rule that one must withdraw a certain minimum amount from the account each year.

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