Funds invested in either a registered retirement savings account (RRSP) and a tax-free savings account (TFSA) grow tax-free while in the account.
However, there is a difference between the accounts in terms of contributions and withdrawals.
Assuming you have sufficient contribution room, contributions to an RRSP are deducted from your income and therefore save you tax in the current year. Contributions to a TFSA are not deducted and therefore come out of your after-tax income.
Conversely, withdrawals from an RRSP are included in your income, whereas withdrawals from a TFSA are not included in your income.
So which account is more advantageous in terms of tax savings?
The answer depends on your marginal tax rate in the year of contribution relative to your marginal tax rate in the year of withdrawal. If the rates in those years are equal, the two accounts are essentially equivalent in terms of tax savings, although due to the deduction, the RRSP will allow you to have more money grow tax-free. If the rate in the year of contribution is greater, you are likely better off with the RRSP contribution. If the marginal tax rate in the year of contribution is less, you may be better off with a TFSA contribution.
This year, you are in a 50% tax bracket. You contribute $2,000 to your RRSP, which saves you $1,000, so that your net investment is $1,000 after tax.
You also contribute $1,000 to your TFSA. Since this amount is not deductible, your net investment is also $1,000 after tax.
Both amounts double in value by a future taxation year. Therefore, the RRSP investment grows to $4,000 and the TFSA investment grows to $2,000. You withdraw both amounts and are again in the 50% tax bracket. The RRSP withdrawal is subject to 50% tax and nets you $2,000. The TFSA withdrawal is not included in your income and therefore nets you $2,000.
On the other hand, if your future tax rate is less than 50%, the RRSP withdrawal would net you more than $2,000. If your future tax rate is greater than 50%, the RRSP withdrawal would net you less than $2,000.
Lastly, it is important to use your “effective” tax rate for the above purposes. For example, if your “regular” tax rate remains the same, but the RRSP withdrawal in the future year would subject you to the Old Age Security clawback tax, or reduce your age credit, your effective tax rate in the future year would be higher than the earlier effective rate. In such case, the TFSA investment would come out ahead.
Note also that TFSA contribution room can be used over and over. If you withdraw funds from the TFSA, your contribution room is increased by a matching amount the next January 1. With an RRSP, your contribution room built up each year is lost once you have used it, and you need additional “earned income” in later years to build up more room. So if you expect that you might need funds on a periodic basis from your plan, a TFSA is better for this purpose.