RRSP or TFSA? Which one is right for you?

This is a common question we get asked a lot, "Should I contribute to an RRSP or a TFSA?". In the perfect world, the answer would be to contribute to both but we all know that we do not live in a perfect world. There are constraints that limit what the average Canadian can contribute to their RRSP or TFSA. To further understand which avenue is best for your personal financial plan, we must first understand the nuances of each investment vehicle.

A contribution to an RRSP creates an up-front tax deduction to reduces taxes payable for the individual, which may involve a tax refund. The maximum you can contribute to your RRSP on an annual basis is 18 percent of your previous year's earned income. After you contribute to your RRSP, the investment earnings within your RRSP account grow on a tax-deferred basis, meaning you do not have to pay tax on any of the interest that is earned on that account. You can invest in just about anything inside of an RRSP that you could outside of an RRSP - so mutual funds, stocks, bonds, or just straight savings accounts

An RRSP can be held until December 31st in which you (the taxpayer) turn 71. At this point, the proceeds within your RRSP must be converted into either a registered retirement income fund (RRIF) or an annuity. The RRIF then has a mandatory withdrawal schedule starting the year you turn 72. Meaning when an RRIF withdrawal or an annuity payment are made, this amount is then taxable at your current effective tax rate.

On the other side of this is a TFSA, any contributions made into this investment vehicle are made with after-tax dollars. There are no tax deductions when a contribution is made, and there are no tax consequences when funds are withdrawn from this account. The current maximum amount you can contribute into your TFSA on an annual basis is $5500. If you have never contributed to a TFSA before, you currently have $52,000 in eligible contribution room, as the annual contributions are retroactive to 2008 when TFSAs were first introduced. As is the same with RRSPs, you can invest in just about anything inside of a TFSA that you could outside of a TFSA - so mutual funds, stocks, bonds, or just straight savings accounts.

TFSAs provide more flexibility in that you can put money in for the short term and know there will not be any tax consequences if you need to withdraw some money. When money is put into an RRSP and has to be withdrawn, in most cases this will be a taxable withdrawal (exceptions being a withdrawal under the first time home buyers plan or to pay for education, both have specified payback times) and your contribution space is forever lost. With a TFSA money can be withdrawn from the account and then within or after the next calendar year you can recontribute the amount withdrawn if the funds become available. 

With the millennial generation not having a lot of disposable income, debt from school they'd like to pay down and they have not started an emergency fund yet, a TFSA probably makes more sense. Start with a TFSA and have a savings goal in mind, say $1000 or $2000, this will create a short term emergency savings fund for you because we all know life happens. The money you put within the TFSA then will grow tax-free. Once you've reached your savings goal, then maybe the time to start looking at contributing to an RRSP. 

On the flip side of this, for somebody in their prime earning years, the benefits of contributing to an RRSP, including an up-front tax deduction, the opportunity to earn investment income on a tax-deferred basis from a variety of instruments, along with a chance to defer withdrawal until retirement when the taxpayer is presumably going to be in a lower marginal tax bracket, might provide the best bang for their buck.

There can also be strategies where both a TFSA and an RRSP could be used, depending on your individual situation. The bottom line is to start saving today, the sooner you start saving the easier it will be to arrive at your savings goals.