Should I contribute to a RRSP, TFSA or Both?

RRSPs can work well if you contribute while you are in a high tax bracket and withdraw when you are in a lower tax bracket. You can generate a higher net rate of return with an RRSP when the effective tax rate at the time of withdrawal is lower than the effective tax rate at the time of contribution. A TFSA can provide a higher return if the reverse occurs.

For example, if you contribute $1,000 to an RRSP when you are in a 30 percent tax bracket, your net cost is $700 after the tax savings. If you are in a 20 percent tax bracket when you make a withdrawal from your RRSP, your net withdrawal will be equal to your net cost after paying the taxes ($800).

Registered Retirement Savings Plan

RRSPs are generally used for saving for retirement. Contributions are tax-deductible and investments grow tax-free within the account. Both the contributions and investment earnings are taxable upon withdrawal, but the idea is that these withdrawals will happen after retirement, when your income and tax rate are expected to be lower than when you contributed. Withdrawals are included in income and affect eligibility for federal income-tested benefits and tax credits, such as child tax benefits and Old Age Security. Once you withdraw funds from your RRSP, the contribution room is gone for good, unless you do so through a program such as the Home Buyers’ Plan or Lifelong Learning Plan.

Tax-Free Savings Account

TFSAs can be used to save for both retirement and shorter-term needs. Contributions are not tax-deductible, but investments grow tax-free inside the account. Amounts withdrawn from a TFSA are not subject to tax and will not affect eligibility for federal income-tested benefits and tax credits. Withdrawals are added back to your available TFSA contribution room in the following calendar year, so there is very little downside to using TFSA savings for mid-sized to large purchases.

Low Income

A TFSA can be an ideal savings vehicle if you are in a low income tax bracket. RRSPs may not be well suited to low income Canadians. The RRSP tax savings are insignificant.

Middle Income

If you are in a middle income tax bracket, there may not be a clear advantage to using one plan over the other. One strategy would be to contribute to your TFSA now and accumulate RRSP room to be used later when in a higher tax bracket to optimize the tax benefits.

High Income

This is a situation where you may want to maximize both your RRSP and TFSA contributions. In fact, the tax savings or refund received from your RRSP contribution could be used to fund the TFSA provided you have sufficient room.

Whether to save in a TFSA, RRSP or Both depends on your savings needs, your eligibility for income tested benefits and your current and expected future financial situation and income level.

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