Should You Contribute to Your TFSA or Your RRSP?

Both are valuable, but in certain circumstances, one may be better than the other.

For years, Canadians have been taking advantage of tax-deferred investment growth in their Registered Retirement Savings Plans (RRSPs). But now, the Tax-Free Savings Account (TFSA) provides Canadians 18 years of age and older with a valuable new opportunity to enjoy tax-free growth. So which one should be your first priority?

There is no right or wrong answer. Both RRSPs and the TFSA are beneficial, and what's best for you will depend on a number of factors. To help you decide, consider the following:

Are you saving for a long-term or short-term goal? RRSPs were designed primarily to provide for a long-term goal - retirement. Because you get a tax deduction for contributing, withdrawals are taxable (unless they're made under the Home Buyers' Plan or Lifelong Learning Plan). In many cases, however, they are likely to be made when you are no longer working and therefore likely to be taxed at a lower rate.

The TFSA, on the other hand, has the flexibility to accommodate short-term goals more easily. While there is no deduction permitted for the contribution, any amount can be withdrawn, tax-free, at any time (subject to the nature of the investments in it) for any reason. In addition, you can re-contribute the full amount of your withdrawal in a subsequent year.

Are you looking for an effective way to split income with your spouse who is taxed at a lower rate than you? The TFSA is ideal for income-splitting. You can give your spouse money to contribute to their TFSA and any income earned is not attributed back to you. Your spouse can make tax-free withdrawals at any time.

Conversely, with a spousal RRSP, the contributions you make will reduce the amount you can contribute to your own RRSP. In addition, withdrawals from the spousal plan will be taxed in your hands if they are made in the same calendar year as a spousal contribution or either of the two subsequent calendar years. After that point, however, both the income earned on the initial contribution and any withdrawals made by your spouse will be taxable in his or her hands.

Do you want to maintain your eligibility for income-tested federal government benefits? Because TFSA withdrawals do not count as income, they don't affect eligibility for income-tested federal government benefits such as the Canada Child Tax Benefit, Working Income Tax Benefit, GST credit, age credit, Old Age Security benefits, Guaranteed Income Supplement or Employment Insurance benefits.

The ideal strategy in most instances will be to contribute the maximum to both your TFSA and your RRSP in order to maximize your tax savings. If this isn't possible, then a CIBC advisor can help you decide how to allocate your contributions and make the most of both types of plan.

The table below outlines the primary differences between a TFSA and an RRSP.

TFSA

RRSP

Each calendar year, you can contribute up to the TFSA dollar limit for the year; unused contribution room can be carried forward

Maximum contribution of $22,400 for the 2011 tax year or 18% of prior year's earned income - whichever is less; less any pension adjustment, if applicable; unused contribution room (see previous year's T4 slip or Notice of Assessment for this amount) can be carried forward

No tax deduction for contributions

Tax deduction for contributions

No tax on withdrawals

Withdrawals are taxable income

Withdrawals can be re-contributed in a later year

When you withdraw money, you lose that contribution room forever

Investments may include mutual funds, stocks, bonds and GICs - just like an RRSP

Investments may include mutual funds, stocks, bonds and GICs - just like a TFSA