What’s an RRSP? What’s a TFSA? Which is right for me?

It’s become the common question in January and February over the past few years in Canada: should I invest in a TFSA or an RRSP. First, we should explain the difference between the two.

What’s an RRSP?

A Registered Retirement Savings Plan helps you save money towards your retirement, and shelters you from tax…at least for now. Money you put into your RRSP reduces the amount of taxable income for the tax year. This year, contributions made between March 2011 and Feb 2012 will effectively reduce the amount of tax you pay on last year’s income. You’re free and clear of tax (and tax on interest earned on it) as long as the money is in your RRSP. You will be taxed on it when you take it out. More on that later.

The sooner you start an RRSP, the more you’re equity will grow. The maximum contribution limit this year is $22,970, but many people don’t use all their space every year, so you may have leftover room from previous years. If you use software like TurboTax year after year, it’ll track your room limits and carry forward any unused space. Any Canadian resident 71 years old or younger can open one. Want to know how much to contribute? The major banks all have RRSP calculators on their websites, and TurboTax has an RRSP Optimizer that will help you choose how much to invest in order to reduce your taxes.

Got it. What’s a TFSA?

A Tax Free Savings Account is a type of savings account with a nice twist. The money you invest and any interest you earn are tax-free. Unlike an RRSP, you don’t have to declare the money you’ve made from them on your income tax return. They’re less restrictive than an RRSP in the sense that you can withdraw money from them whenever you love, with no penalty. There is a TFSA contribution cap of $5000 per year. Anyone 18 and older can open a TFSA.

So, which is best for you?

You can invest in both, but if you want to choose one or the other, think about your current financial situation and take a look into the future and guess where you’ll be down the road.

As we learned above, RRSPs give you tax shelter now, and TFSAs are tax free when you withdraw the money, including the interest you made.

If you think you’ll be in a lower tax bracket when you need to access the money later in life, the RRSP will benefit your richer current self as you’ll get relatively bigger tax relief now and a smaller tax burden later. If on the other hand you expect to be making more money when you start withdrawing, a TFSA is the better option because you’re paying less tax now, and your richer future self will avoid paying a higher rate in the future.