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Tax Free Savings Account (TFSA) or a RRSP?

Tax Free Savings Account versus Registered Retirement Savings Plan

In many ways, the TFSA shares some similarities to the registered retirement savings plan (RRSP) and even registered education savings plan (RESP).  There are many issuers in the market (banks, financial institutions, and brokerage firms) who offer consumers these savings and investment vehicles. 

There are, however, some differences in the two investment choices. 

·        You do not have to pay any tax on withdrawals from the TFSA.  In RRSPs, the contributions and income that accumulate are taxable on withdrawal. A TFSA therefore helps account holders to generate tax-free investment income (dividends, interest, and capital gains) earned on the pre taxed contributions.

·        TFSAs a maximum contribution room of $5000 which is much lower than the allowable contribution in a RRSP which is 18% of the ‘earned income’ in an accounting year to a maximum of $20,000.  People who have a higher propensity to save are more likely to prefer RRSP over TFSA.  However a good idea is to max out the contribution limits if you are in a higher income group.  If you are in a lower income group you must max out the contribution in a TFSA and then contribute to the RRSP.

·       The tax benefit will not be lost if you withdraw an amount from a TFSA.  There is a provision of contribution rollover to the subsequent years which is equal to the withdrawal amount or the remaining balance in a year.  Say for example, a person deposits $5000 in a TFSA.  Later he withdraws $3000.  In the following year he can save as much as $8000 without losing any tax benefit.  Therefore, a TFSA is much more flexible than an RRSP where the balance of the contribution is lost if you do not reach the limit in any year.

·        One of the key factors in the choice between any savings and investment option is calculation of how much tax you are really saving.   You must compare the marginal tax rates at the time of contribution to these accounts and the marginal tax rates at the time of future withdrawals.  Obviously people are in a lower tax bracket at the time of retirement.  For example, the RRSP is a better savings option for those with working taxable incomes over $37,000 that expect to retire with an income between $15-31,000.  RRSP is certainly a popular savings option among high income individuals.  On the other hand TFSA is a better choice for people earning less than $37,000 per annum.

Please note that these two savings options are not competing or alternate options.  Ideally a person must invest in a TFSA but only after making the maximum contribution to an RRSP (which gives an immediate tax break because it can be deducted from income). Similarly he must also consider investing in the RESP as any contribution to this account makes you eligible for the Canada Education Savings Grants (CESG).  For example it is advisable to contribute enough (almost $36,000) to the RESP to get the maximum allowed CESG of $7,200 per child.  If you still want to save more than consider opening a TFSA.

You must consider making TFSA a part of your overall saving strategy.  There is no need to close your RRSP, for now… Finally, a sound savings strategy and advice from a qualified professional can help you save the most.

This entry was posted on Wednesday, May 7th, 2008 at 8:24 am and is filed under TFSA & RRSP. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

One Response to “Tax Free Savings Account (TFSA) or a RRSP?”

  1. findcheapinsurance » Blog Archive » Tax Free Savings Account (TFSA) vs. The RRSP | Tax Free Savings … Says:

    […] In RRSPs, the contributions and income that accumulate are taxable on withdrawal. A TFSA therefore helps account holders to generate tax-free investment income (dividends, interest, and capital gains) earned on the pre taxed … Read more here […]

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