TFSA or RRSP? Which makes the most sense for you?

It seems the comparison of the Tax Free Savings account (TFSA) versus Registered Retirement Savings Account (RRSP) is still often misunderstood.

At the risk of over-simplifying , let’s start with some fundamentals.

RRSP	TFSA
Contribute up to 18% of previous year’s earned income, to a maximum of: $24,930 for 2015 tax year $25,370 for 2016 tax year $26,010 for 2017 tax year $26,230 for 2018 tax year $26,500 for 2019 tax year	Contribute after age 18 effective Jan 2009 2009-2012 Annual Limit $5,000 2013-2014 Annual Limit $5,500 2015 Annual Limit $10,000 2016 - 2018 Annual Limit $5,500 2019 Annual Limit $6,000 (until Federal Budget changes)
Tax deduction on contribution amount Withdrawals are taxable This is considered tax deferred	No tax deduction on the contribution amount Withdrawals are not taxable This is considered tax free
Amounts withdrawn are not added back to your contribution room	Amounts withdrawn are added back to your contribution room in the next calendar year

An RRSP is best used when you contribute in a high income tax bracket and withdraw in a low income tax bracket.

If you need the tax deduction and can reasonably say your income will be lower when you withdraw the funds later in life, then an RRSP could work well in your investment plan.

If you contribute $10,000 in a year when your income tax bracket is high (50%), you defer paying $5000 in taxes that year. When you withdraw at a low income tax bracket in retirement (30%) you pay $3000 in taxes. By deferring the withdrawal of funds until you are in a low tax bracket you save $2000 in taxes. Multiply this by years of contributions and the effect can be significant.

If you aren't careful when planning this same concept can also work to your disadvantage. By contributing the same $10,000 when your income tax bracket is low (30%) you will defer paying $3000 in taxes that year. However, if you withdraw at a higher tax bracket (50%), you will $5000 in taxes. The end result will have you paying $2000 more in taxes.

In a TFSA, the growth is tax-free rather than tax-deferred.

True, there is no immediate tax write off, however you do not pay tax when you withdraw. These two go hand in hand. The TFSA offers greater flexibility to withdraw funds with no tax consequences. Plus, the amount you withdraw is added back to your contribution limit for the next year. You can repeatedly deposit and withdraw within your limits without trigging any tax consequences if necessary. However the long term benefits of saving in a TFSA and leaving your investment to grow tax sheltered can be significant in the long run.

Some examples of Canadians who can benefit from using a TFSA include:

Young people starting at low income levels saving for either short or long term needs like a home, vacation or retirement
Business owners who reduce annual personal income and may retire in a higher tax bracket upon sale of business
Retirees looking to shelter investment income to avoid clawback from OAS.
Someone temporarily in a low income tax bracket (Maternity leave). They could use a TFSA for now and move to an RRSP when they are in need of a tax write off and deferral.
High income Canadians with maximized RRSP looking to save additional funds outside their RRSP. The TFSA should ideally be maxed out annually before other non-registered investments are used.

To determine if you should contribute to an RRSP this year ask yourself: Was my income tax bracket last calendar year more likely to be higher or lower than it will be when I plan to take the money out in retirement? If the answer is higher, then the RRSP could fill your needs this year. If the answer is lower, then I would lean towards a TFSA.

Similar to an RRSP, you can invest your TFSA in a wide range of qualified investments like investment funds, stocks, bonds, GIC’s or cash accounts. The type of investment will depend on your investor profile and should be determined by you and your financial advisor.

This is a simplified approach to help with basic understanding, and it is important to note there may be other factors to consider specific to your personal situation. Your financial advisor can help take a closer look at your overall financial plan to determine whether an RRSP, TFSA or combination is right for your personal situation.

This column originally appeared in Elgin This Month February 2011 edition and has been updated in 2019.