While there are several Canadian savings-oriented tax-sheltered investment vehicles to which you can contribute, we’d like to address two that are frequently discussed: Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs). The ideal scenario is where you have enough money to max out your contribution room every year to both. However, for many Canadians, that is not possible. So if you can only contribute to one of the plans, how do you go about choosing?

Below, we break down the merits of contributing to a TFSA versus an RRSP. As you’ll see, like many questions in the world of saving money, the decision ultimately rests on your own personal situation.

What are TFSAs and RRSPs?

RRSPs have been around since 1957 and for decades were the only tax-sheltered savings option for Canadians. For 2014, Canadians were able to contribute 18% of their earned, pre-tax income in 2013 up to a maximum of $24,270 (whichever is less). Earned income includes things like wages, rental income, research grants, and income from a business owned by an individual. Any RRSP contributions can then be deducted from your income in order to reduce the amount of tax payable. RRSPs must be wound up by age 71, which means they either must be completely collapsed, or converted into a Registered Retirement Income Fund (RRIF) or an annuity. Completely collapsing the RRSP (i.e. converting to cash) can result in a huge tax bill, so this is not a commonly used approach. RRIFs and annuities provide a steady stream of income during retirement and are much more tax-friendly.

TFSAs were introduced by the Canadian government in 2009 and were set up to motivate Canadians to save money through an incentive of earning interest tax-free. All Canadians 18 and over may contribute up to $10,000 per year to their TFSA. As of 2015, the cumulative contribution room is $41,000, if you were born before 1992 and have a valid social insurance number. This means that if you don’t max out your contribution one year, it carries over to the next year. Unlike RRSPs, contributions to TFSAs are not tax-deductible. However, money withdrawn from a TFSA is not taxable because it in effect has already been taxed before going into the structure. As with RRSPs, capital gains and interest income earned while in the TFSA are also not taxable.

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How to Decide Which One to Contribute To

Many Canadians simply don’t have enough money at the end of the year to max out their RRSP and TFSA contributions. This leaves them with a dilemma: which one to choose?

Tax Savings

While there are many factors to consider when deciding whether to contribute to an RRSP or TFSA, the big one is taxation. Financial advisors typically recommend that if your current income is higher than the estimated income being generated at retirement, you should contribute to an RRSP. After all, by making an RRSP contribution, you lower your taxable income while you’re in a high tax bracket (and possibly even reduce your income to a lower tax bracket).

On the other end, when you retire, your income will be taxed at a lower rate. This is important because RRSP withdrawals are counted as income. For example, say you’re in a 40% tax bracket (federal + provincial) now and you want to contribute $5,000 to an RRSP. By making the contribution, you will receive a $2,000 refund from the government ($5,000 x 0.40). But let’s say that your tax bracket in retirement is only estimated to be 30%. When you withdraw that same $5,000, you will pay $1,500 in taxes. You will have saved $500 in taxes by making the RRSP contribution, not to mention any investment gains made by the RRSP.

However, if you think your income will be higher in retirement, it makes sense to choose the TFSA. You will be contributing $5,000 of after-tax dollars when your tax rate is 30% (so you’ve paid $1,500 in taxes on that money), and taking it out when you’re in the 40% bracket, tax-free. A key consideration here is whether you have or expect to have a solid pension plan. Once your total income is above $71,592, the government starts to “claw back” some of the Old Age Security you receive. (This is a reason not to go the RRSP route).

Ease of Access to Your Money

When you contribute to an RRSP, it is very difficult to withdraw any money without incurring a tax penalty. Only in two cases, which we describe below, are you allowed to make a withdrawal tax-free. This is both an advantage and a disadvantage. On the one hand, it means you may have money you can’t readily access, which might force you to borrow and pay interest. However, it also means that you likely won’t be tempted to take any money out of the RRSP and spend it. In this regard, as personal finance expert David Chilton has argued, it’s the epitome of a forced savings plan.

The opposite, of course, is true with TFSAs. Money can be withdrawn tax-free from a TFSA at any time, so there’s always the temptation to turn to withdraw it when you need the money. This can be a bad idea if you’re only using the TFSA to cover something like a vacation, but it may make sense to tap into the structure for something you really need, such as medical expenses.

Guaranteed Income Supplement

Lower income Canadians may apply in retirement for the Guaranteed Income Supplement (GIS) over and above the basic Old Age Security payments that most retirees receive. If you think you might be in this situation during retirement, it makes sense to choose the TFSA over the RRSP when deciding where to contribute, because income aside from GIS payments is taxed at a punitive 50% rate.

What Are You Saving For: Retirement or a Major Purchase?

When you’re deciding where to contribute, it’s useful to ask yourself what you are saving for. If you were saving to buy a car, for example, then you would choose the TFSA because the money would be withdrawn tax-free. So with the TFSA you can choose to save for retirement, but because you are investing after-tax dollars, you don’t incur a big tax bill when you pull money out.

The RRSP is much more restrictive. Currently, the government only allows early RRSP withdrawals without penalty for two reasons: the purchase of a house and the financing of an education. In the case of the former, only $25,000 can be taken out and it must be repaid within 15 years. With education expenses, $20,000 may be withdrawn tax-free up to a maximum of $10,000 per year, and it too must be repaid into the RRSP structure. Other than these exceptions, early RRSP withdrawals are subject to significant tax penalties. To sum up, both the TFSA and RRSP can be used for retirement savings, but the RRSP is really retirement-only, with the two exemptions we discussed.

Assess Your Current and Future Needs

In any case, the important thing is to ask yourself what you’re saving for and how you see your post-retirement tax bracket vs. your current one. If you are planning on using the money for retirement, and you believe your income will be lower after age 71 than it is now, you are probably best to go with the RRSP. Conversely, if you are either saving for a major purchase or believe you will be in a higher tax bracket come retirement, a TFSA might be more appropriate. There isn’t a one-size-fits-all answer so it really does depend on what you need now and how you see your income and tax situation in the future.