This is a very common question because the two programs have many similarities, but also a few key differences. In general, TFSAs are more appropriate for people who expect their incomes to rise over time (often, young people), whereas RRSPs are more appropriate for those with already high incomes or who expect to see their incomes stay the same or decline.
Here are the primary differences between the accounts:
- The RRSP tax deduction is a very important element of the plan. For most people, it allows for tax minimization by delaying tax remittance from working years, when incomes and tax rates are higher, to retirement years, when incomes and tax rates are lower. This deduction becomes more beneficial as a person’s income and tax rate increases. A person with a marginal tax rate of 50% who makes a $20,000 RSP contribution receives a $10,000 refund; a person with a marginal tax rate of 20% who makes the same contribution receives a refund of only $4,000.
- It is possible for some people – diligent savers, high earners, and people who will receive large inheritances or gifts – to have higher incomes in retirement than in their working years. As a result, some people will end up paying more taxes when utilizing the RRSP than not.
- Neither RRSP nor TFSA contribution room disappears if unused. As a result, if a person expects their income to increase significantly in the short-term, it can be advantageous to hold off on RRSP contributions until the deduction becomes for valuable, and to make TFSA contributions in the meantime instead.
- TFSAs are versatile. Money can be deposited and withdrawn with few restrictions. This means the TFSA can be used to save for major purchases, such as buying a home, while allowing the investments to grow tax free, and full contribution room will be restored on January 1st of the year following any withdrawals. On the other hand, RRSPs are less versatile. Since all withdrawals are fully taxed as income, unanticipated withdrawals during working years can be taxed heavily. As well, the contribution room originally used is permanently lost on withdrawal.
In short, here are the three major factors and their impacts on the decision.
- Income today vs. in the future
- Expect to have higher income in the future? TFSA is relatively more attractive right now.
- Amount of savings room available
- For most people, the TFSA has substantially lower lifetime contribution room for most people, so it is maxed out more quickly.
- Whether flexibility is important
If the funds might be required for something other than retirement, the TFSA is more appropriate.