Which retirement savings direction is right for me; TFSA or RRSP?

No doubt, these two saving options offer you tax advantages to help you save as much as you can and reach your saving goals. Saving is a tough challenge with all the financial demands of everyday life. Making investments has its problems too especially if you don't have enough information on all your savings options.

Let us take a quick look at two of the best ways to set up a savings plan; your traditional RRSP and the newer kid on the block TFSAs.

When you decide to make RRSP contributions, the deductions are made from your taxable income. In other words, you get to deduct that amount from your taxable income, giving you a tax rebate. The invested amount in your RRSP grows free of tax while the money is still in the plan, but the bitter pill is when you withdraw the funds directly from the RRSP or from the registered retirement income fund(RRIF) to which the RRSP may have been converted to, it becomes taxable. Meaning, you will have to pay taxes on 100% of the money redeemed.

On the other hand, TFSAs are different in that you don't get any deductions when you contribute to the fund. But the money grows free of tax in the account and comes out tax-free on withdrawals. As a result, you do not pay taxes for the growth of that money while it was in the plan.

TFSA's are a fantastic way to grow your money and not get a big surprise bill from the tax man when you pull it out. But that doesn't mean the RRSPs aren't all bad either. But TFSAs are often your best deal and less confusing when it comes to what you will owe to the tax man in the end.

In the case of RRSP withdrawals, you pay tax because you made the contributions with pre-tax money and were able to deduct your investment. TFSA withdrawals are tax-free because you made the contributions with after-tax dollars.

When does it make sense to invest in RRSPs?

You should note that, if your marginal tax rate at the time you made your contribution to the RRSP is the same as at the time you withdraw it, then TFSAs and RRSPs work about the same.

RRSP's become a better option if you discover that at the time of withdrawal your tax rate will be lower than the time of contribution. But if you find your marginal tax rate is higher on the other end at the time of withdrawal than when you make the contribution, TFSA is the better deal.

Understanding what your marginal tax rate may be at the time of your withdrawal, will give you a good indication of which direction to take.

Here is a simple example of how this works:


Pre-tax Income = $5,000

(0 tax on this money as an RRSP contribution)

Net Contribution = $5,000

Investment Value 20 years later @ 6% growth = $16,035

Tax you pay upon withdrawal (30.5%*) = $4,890

Leaves you with = $11,145


Pre-tax Income = $5,000 (less tax you pay to earn that $5,000 = $1,525)

Net Contribution = $3,475

Investment Value 20 years later @ 6% growth = $11,145

Tax you pay upon withdrawal (30.5%*) = 0

Leaves you with = $11,145

*assumed marginal tax rate

The above example demonstrates what each savings option is when the marginal tax rate is the same. But you should be able to assess how the money you are left with at the end will change if you are paying more taxes at the beginning or at the end.

Canadians tend to be drawn to RRSPs because of the refund they may receive from their recent RRSP contribution. But spending that refund can cost you more then you realize if you don't use it right. It can be tempting due to the relief it may give you in other ways. But often from a long term financial planning point, TFSAs will cost you less in the end. If you can avoid the temptation of spending the refund on a trip or new toy, and reinvest the refund, then your RRSP will help you earn a little more money, not to say more than the TFSA, but it will benefit more than by spending it.

Here is what it looks like if you were to put the extra money you would saved in tax from your RRSP contribution into a TFSA:

Pre-tax Income = $1,525

Net Contribution = $1,525

Investment Value 20 years later @ 6% growth = $4,870

Tax you pay upon withdrawal (30.5%*) = 0

Leaves you with = $4,870

That extra $1,525 you could have spent from an RRSP deduction gained you $4,890 in the end by putting it into a TFSA instead.  By saving the RRSP deduction into a TFSA would increase your total savings by 43% over that 20 year period and that increase is tax-free. Your end result of $11,145 is now $16,035 net of tax.

Another point to consider,  when you make RRSP/RRIF withdrawals, you not only have to pay taxes on that redemption, your increased income could also have an impact on your old age security pensions. The projected income increase might lead to higher clawbacks even on guaranteed income supplement, and other government-issued benefits.

There are various assumptions and questions to take into consideration. Such as; can you properly guess at what your taxable income will be 10 to 30 years ahead? What about the expected future rates? In retirement, will you be in a position to income split with your spouse or will your spouse already have split with some of your income? Will clawback rules be altered?

This comparison is challenging, and many people tend to assume that every dollar withdrawn from RRSPs and TFSAs will be taxed at the marginal rate which isn’t true. The point is usually considered lightly but unfortunately cannot be ignored as it is one of the crucial aspects of evaluation.

So where to get on board?

Honestly, this decision is not a simple one and its best to consult a professional financial advisor that can review your unique situation and chart a course for smoother sailing, giving you a more accurate picture of what truly lies ahead for you.

Based on the various assumptions used in the comparison scenarios. TFSAs is undoubtedly the best saving strategy to go for especially for the low-income earners. The reality is TFSAs are more flexible as you can withdraw money out at any time and put it back later in future years. That flexibility might serve as an advantage or disadvantage to you. Whereas an RRSP is complicated to withdraw from because of the tax planning that must be considered at time of redemption and how it will affect your annual tax filing.

Bottom line: If you go the TFSA route, don't spend your TFSA. If you go the RRSP route, then don't waste your refund!. The last and most important point, whatever course you take save as much as you can!