A common question is whether an individual should maximize their RRSP or TFSA contribution.
It is an excellent question without a simple answer as it can differ dramatically from individual to individual. Although they are both savings vehicles, they are very different so let us explain.
RRSP – a Registered Retirement Savings Plan (RRSP) contribution is made with ‘before’ tax dollars and is a tax deferral vehicle. An individual receives a tax benefit in the year of the contribution but will pay taxes when the funds are withdrawn during their retirement. The rule of thumb with respect to the RRSP is to make a contribution when your tax rate is higher than during your retirement. However, it is also not a flexible program so do not make RRSP contributions if there is a reasonable chance you will need the funds prior to retirement.
TFSA – a Tax Free Savings Account (TFSA) contribution is made with ‘after’ tax dollars. There are two primary benefits with a TFSA account. Firstly, any interest, income and capital gains in the account are not taxed. Secondly, a TFSA is a very flexible vehicle as it is easy to withdraw funds. For example, an individual can use a TFSA to save for the purchase of a house. The funds can be withdrawn when needed but you do not lose the room. The funds can be re-contributed at a later date.
Optimization Strategy – the ideal strategy is to make your maximum contribution to your RRSP and then use your tax refund as a contribution to your TFSA.