TFSA or RRSP? It all depends, advisers say

Every year, in the dead of winter, Canadians are urged to start thinking about retirement.

Put your money in a registered retirement savings plan (RRSP) or a tax-free savings plan (TFSA), we are told, and dream of the day you can walk away from the workplace with a financial nest egg to carry you to the end of your life.

Banks, personal finance experts and even Canada's finance minister are keen on Canadians saving for their own retirement. Too few Canadians have retirement plans through their employer and CPP/OAS, with benefits of just over $16,000, pay too little to support most of us with the lifestyle we enjoy now.

But which should you choose – TFSA or RRSP?

Introduced five years ago, TFSAs allow you to save up to $5,500 a year, in the investment vehicle of your choice, with no tax on the interest or capital gain you receive. Even when you withdraw the money, you pay no tax.

Most TFSAs are invested in GICs or high-interest accounts, but, because the funds grow tax free, investments that draw dividend income or have capital gains might be a better investment for TFSAs. Some alternatives are mutual funds, equities or bonds.

RRSPs also grow tax-free, with the additional advantage that you get a tax deduction this year for every dollar you put into a retirement plan. And any unused contribution room you have from past years is carried forward so you can use it for later years. The deadline for putting money into an RRSP for the 2013 tax year is set for Monday, March 2.

In return for a tax deduction now, you will owe tax on that money when you withdraw it in retirement.

So how to weigh a tax deduction now, against tax-free withdrawal after age 65? Financial advisers say it all depends on your tax bracket, your age and what income you expect to have after retirement.

You want to reduce your taxable income for this year: Any contribution to your RRSP comes directly off your taxable income, with the potential to push you into a lower tax bracket. When you get that refund cheque, put it into your RRSP plan for next year.

You want a steady stream of income from your savings in retirement: An RRSP gives you the chance to save more (18 per cent of your income to a maximum of $23,820 in 2013). This can build, with savvy investment, into a nest egg that will give you a steady income in retirement. You will pay taxes on any RRSP savings you withdraw in retirement, but your tax rate is likely to be low as your income will be lower than when you were working.

You need to put your money somewhere you won’t get at it easily: There’s no penalty to withdraw from a TFSA – if you think you might need that cash, that’s the place to put it. But there is a withholding tax when you take money from an RRSP, which can discourage any plans to take it out for a vacation or other purchase you could easily postpone.

​You've used all your RRSP room: TFSA gives your money a place to grow tax free.

You are young and your income is low: If you are in a low tax bracket, you get less benefit from the refund you get from an RRSP contribution. But if you save the RRSP contribution room until your 30s or 40s, when you are earning more, you will get a big bang from your tax refund.

You might need capital after retirement: If you think you might need capital to renovate a home or buy a property in a warmer climate after retirement, then your savings are better off in a TFSA. Any big RRSP withdrawal will be taxed as if it were income, but you pay no tax on a withdrawal from a TFSA.

You are unlikely to have income other than CPP/QPP and OAS after retirement: If you have no pension income other than CPP/QPP and OAS, an RRSP withdrawal may push your overall income in retirement to the level where you will no longer qualify for government benefits such as the Guaranteed Income Supplement (single cutoff is $16,728 annually). Your OAS benefit may also be clawed back at tax time if you take enough money from an RRSP to push your income beyond $71,592.