TFSAs vs. RRSPs

When the new year rolls around and tax season begins, you might find yourself debating the best way to use your investment dollars: should you stash your cash in your Registered Retirement Savings Plan (RRSP) before the tax deadline or contribute as much as you can to your Tax-Free Savings Account (TFSA)?

Deciding on the best option can be challenging. Both are tax sheltered investments but each offers different benefits and, depending on your financial situation, one may be a better option for you.

If you want to maximize your investment dollars, here are three points you should consider.

Both RRSP and TFSAs are vehicles where your investment can grow free of tax. TFSA contributions are not tax deductible, whereas your RRSP contributions are. However, when it comes to withdrawing your funds, it’s the other way around: your RRSP withdrawals are taxed as income, whereas your TFSA withdrawals are not.

If you find that you’re having a hard time putting money aside regularly without spending it, the withdrawal penalties that come with the RRSP might prove a useful incentive to not touch the funds you’re squirreling away.

There are also tax implications when it comes to your estate. With an RRSP, money from your account will go to your spouse tax-free as cash, but your heirs will have their inheritance taxed.

On the other hand, with a TFSA, the savings will be transferred to your spouse’s TFSA and your heir will receive their inheritance tax-free.

The contribution room for both TFSAs and RRSPs carries forward year after year, which means that if you do not max out your contribution one year, it is not forfeited but is cumulative year after year. To find out what your total available contribution room is, refer to your last notice of assessment.

For RRSPs, that annual contribution limit is the lesser between 18% of your earned income for the previous tax year and the maximum contribution amount set by the CRA for the current tax year.

Another significant difference between the two accounts is what happens when you withdraw money from them.

When you make a withdrawal from your TFSA, that frees up your contribution room for next year's deposits. On the other hand, if you make a withdrawal from your RRSP, the contribution room is gone.

The differences in available contribution room between TFSAs and RRSPs serves as a decent illustration of how you can use both accounts to save for your retirement: the RRSP has much more heft to it whereas the TFSA is much lighter, useful to get you started or as an added bonus.

To open a TFSA, you must reach the age of majority (which in British Columbia is 19), whereas to open an RRSP, you just need to have income.

However, when you turn 71, your RRSP is converted to an RRIF and you must begin withdrawing your funds. There is no such age limit for TFSAs. You can keep investing in them as long as you like.

RRSPs are designed specifically for your retirement. That was what they were intended for and that is how they work best.

TFSAs on the other hand were made to maximize flexibility while still allowing your investments to grow tax-free. TFSAs are good ways to achieve your long-term savings goals (like retirement) but are also powerful tools for those short term goals you might have (planning for your vacation).

Any long term retirement saving strategy will likely use both TFSAs and RRSPs. The question is, which should you prioritize now?

For every situation, there is a unique plan. Your earnings, your debt level, your net worth, your hopes and dreams, your past financial history, your current situation, your risk aversion, your time horizon, all play an important part in determining what your strategy should be.