Trying to decide whether you should invest in a TFSA or an RRSP? You’re not alone! Generally speaking, higher income earners will be better served by an RRSP, while those making an income of under $35,000 should opt for a TFSA. But what about the moderate income earner, you ask? Let’s break things down and see.

What is an RRSP?

RRSPs are a tax savings vehicle which allows you to defer paying income taxes on the amount you contribute to a later date. Your latest RRSP deduction limit is presented each year on your federal notice of assessment. Not only is unused contribution room carried forward to future tax years, if you’ve contributed to an RRSP, you can delay claiming the deduction to future years as well. Various types of investments can be places in an RRSP account, such as: GICs, certain stocks, mutual funds and bonds. Prior to placing certain investments in an RRSP, you should ensure that they are qualified investments to avoid negative tax implications. The amount you contribute to an RRSP (plus any income earned within the RRSP) is taxable only once you withdraw the funds. The basic idea of an RRSP is that you will only use the funds once you’ve retired, when you are presumably in a lower tax bracket than during your income earning years. Other points to keep in mind are that you can contribute to your spouse’s RRSP (which allows for future income tax splitting) and that you can only contribute to your RRSP until December 31st of the year in which you turn 71 years old.

Generally, when you withdraw from your RRSPs, you do not regain any contribution room (see exceptions discussed below).

What is a TFSA?

Only recently introduced in 2009, the TFSA allows you to contribute up to $5,500 per year (as of 2016) once you reach the age of 18. Similar to RRSPs, TFSAs allow you to invest in a combination of investments, such as: GICs, high interest savings accounts, stocks, bonds and more. The major difference is that your TFSA contributions are considered after tax income, therefore you do not get a tax deduction when you invest in a TFSA. The benefit of a TFSA is that the income you earn in the TFSA is tax free. Therefore, you can withdraw any amounts (including the amount you originally contributed, since you paid tax on it prior to contributing) tax free. Income splitting is also possible with a TFSA. You can give your spouse money to contribute towards TFSAs and any income earned is not attributed back to you.

Unlike RRSPs, withdrawals from your TFSA are added back to your TFSA contribution room on January 1st of the following year.

When a TFSA is better

If you are currently in low tax bracket and expect to be in a higher tax bracket in the future (but prior to retirement), it is generally better to make use of your TFSA first and use your RRSPs when you are in a higher tax bracket (and can get a larger tax deferral). If you’ve maxed out your TFSA, you can still contribute to your RRSPs and delay taking the deduction until you’re in a higher tax bracket.

If you anticipate being in a higher income tax bracket at retirement than during your working years, RRSPs will hinder your tax savings. The combination of your income from your pensions and your RRSP withdrawals in retirement could push you into a higher tax bracket than when you were employed. Furthermore, withdrawals from RRSPs can lead to clawbacks of Old Age Security and other government income-tested benefits.

When an RRSP is better

If you are a high-income earner and expect to be in a lower tax bracket after retirement, RRSPs are an effective way to save on your current income tax, while building yourself a nice nest egg for the future.

If you plan on purchasing your first home in the near future, or pursuing post-secondary school there are two RRSP plans which can provide much needed financial assistance. You can borrow back on your RRSPs on a tax free basis in two circumstances; when you purchase your first home through the Home Buyer’s Plan (HBP) or if you decide to pursue full-time education from a post-secondary education institution through the Life Long Learning Plan (LLP). Both require that you repay the amount you borrowed until it’s fully paid back, however, the repayment of your RRSPs is not tax deductible.

Be sure to check out our other blog posts for more financial and accounting advice.