With the Tax Free Savings Account still being a relatively new thing, many people may be left wondering
“Registered Retirement Savings Plan or Tax Free Savings Account? What's the difference and how can I choose which one is right for me?” In fact, it may not be a question of which one, but of what balance. TFSA's offer tax free earnings, whereas RRSP's are tax deferred. RRSP contributions are deducted from your taxable income, effectively reducing the amount of income you have to pay tax on; however, when you take this money out later in retirement, you pay tax on it then. So the question, “RRSP or TFSA?” depends on
your specific situation.
If you are in a higher income tax bracket, then your tax savings are greater than if you were in the primary tax bracket. For example; for someone in Ontario in the primary tax bracket there would be a savings of 20.05% of your RRSP contributions (15% federal tax and 5.05% Provincial). The next marginal rate would be 31.15% (22% federal and 9.15% provincial). If you contribute while in the primary bracket, and take your money out in retirement in the primary bracket (presuming federal and provincial rates stay the same), then you will have to pay the EXACT same PERCENTAGE of tax.
Your return on investment in an RRSP is the same as in a TFSA because you can invest in the same things; however, with an RRSP you will end up paying income tax on the investment return whereas in the TFSA the earnings are tax free.
If you are making your RRSP contributions while you are in a higher tax bracket than when you withdraw the funds; there will be a net tax savings. Using the example from above; contributing while in the 31.15% tax bracket and withdrawing the funds in the 20.05% tax bracket would give a tax savings of 11.1%.
The other advantage RRSP's have over TFSA's is the contribution room. TFSA's allow for $5,500 per year to be contributed with unused contributions carrying forward indefinitely. As of today, if you have never contributed to a TFSA, you have $31,000 of contribution room. Alternatively, you can contribute 18% of your earned income into your RRSP up to a maximum of $24,270 for 2014 alone, plus any unused contributions from 1991 onward. There are some factors that affect your contribution room such as registered pension plans, but the main point here is that RRSP's have much greater contribution room than do TFSA's.
One of the advantages of a TFSA is the ability to take money out, without penalty or payment. You can even re-contribute the amounts you withdraw as long as it's not done until the following year; otherwise, you will potentially be dealing with penalties for over contributions. If you take money out of your RRSP, you will have to pay tax on the full amount.
RRSP’s offer a means by which you can contribute relatively large amounts of money and to defer the income tax on it and TFSA’s offer a way to contribute smaller amounts tax free. RRSP’s are better suited for long term, retirement savings and TFSA’s would be more suitable for shorter term savings, such as home renovations, vacations or as a supplement to your retirement savings.