There are any number of savings vehicles out there for Canadians to choose from. But if you can afford to contribute to only one vehicle, which one should you choose, an RRSP or a TFSA? Let’s look at a particular scenario in detail.

Favouring the RRSP

Anne established her practice four years ago. She is unincorporated and finally has a surplus of $4,000, which she intends to put toward retirement. She plans to continue saving with an annual increase of 10 percent (i.e., next year, she’ll save $4,400) without withdrawing the funds until she retires. She’s deciding between an RRSP and a TFSA, and she’s more interested in an RRSP because of the immediate tax savings. After all, for an unincorporated business, an RRSP provides a significant tax break.

Anne had a taxable income of $40,000 last year, allowing her to contribute up to $7,200 to an RRSP this year. And, as a Canadian resident over the age of 17, she can contribute up to $10,000 (2015 limit) to a TFSA. The marginal tax rate in Ontario at that income level is currently 20.05 percent. Every year, Anne will invest in the same investment product, whether she decides to contribute to an RRSP or to a TFSA, and it will have an annual growth rate of 10 percent. Consider the difference between the two vehicles using a five-year time frame.

RRSP Option – Anne can contribute $4,802 to an RRSP after a tax refund of $802 ($4,000 x 20.05 percent) in the first year. Five years later, the contributions will grow tax-free to $37,965, with an annual return assumption of 10 percent.

TFSA Option – Anne can contribute only $4,000 in the first year (as opposed to $4,802) to a TFSA because she won’t be entitled to a tax refund. Five years later, the contributions will grow tax-free to $31,625 (see Figure 1).

Figure 1: SAVING FOR RETIREMENT

It’s clear Anne will end up with a larger balance if she contributes to an RRSP. However, RRSP withdrawals are taxable, and the future tax bills depend on the future tax rates Anne is subject to. And Anne has to consider other factors. For example, RRSP withdrawals could affect the amount she receives from Old Age Security and the Guaranteed Income Supplement.

Favouring the TFSA

Now, instead of saving for retirement, Anne wants to save for her one-year maternity leave (planned for five years from now) and expects her tax rate to be 20 percent during that year because she’ll be entitled to employment insurance benefits. Under these circumstances, Anne will be better off contributing to a TFSA. The advantage of a TFSA over an RRSP is a difference of $1,253 (see Figure 2).

Figure 2: SAVING FOR MATERNITY LEAVE

While this example shows there is really no right or wrong savings vehicle, you’ll need to consider several factors. And the first one is the most important: What will you be saving for?