When it comes to saving for retirement, Canadians often have a co-nundrum—invest in a registered re-tirement savings plan (RRSP), or consider a tax-free savings account (TFSA)? What makes the most sense? There’s no easy answer. The decision depends on many variables, including an investor’s personal financial situation. 

TFSA: The basics
TFSAs allow Canadian residents to contribute up to $5500 annually (as of 1 January 2013). Although the con-tributions are not tax deductible, the investment income earned within a TFSA is tax free, as are any capital gains. Beginning in 2009, Canadian residents 18 or older were able to accumulate $5000 of TFSA room on an annual basis. Any unused contribution room from previous years (up to $5000 annually from 2009 to 2012) can also be carried forward indefinitely. 

While most Canadians tend to use their TFSAs as emergency funds, or leave them in a short-term investment such as a savings account, there are many other ways to make a TFSA work to your advantage. 

Key differences 
Both TFSAs and RRSPs offer tax advantages, but several key differences exist. 
•    Unlike an RRSP, any amount withdrawn from a TFSA in a given year is added back into an individual’s contribution room for the following year. So if an individual chooses to withdraw TFSA funds, the next year he or she can re-contribute the same amount withdrawn. 

•    Unlike RRSPs, TFSA contributions are considered after-tax funds. Any income and gains derived from investments in a TFSA are not taxed annually, and can also be withdrawn, tax free, at any time. 

•    Because TFSA withdrawals are tax free, government benefits and income-tested tax credits are not reduced, as they are with funds withdrawn from an RRSP or registered retirement income fund (RRIF).

Unlike with an RRSP, TFSA contribution room is not based on earnings. Every Canadian resident who is at least 18 years old and who has a social insurance number is eligible to open a TFSA. Every year, provided the individual files an income tax return, $5500 is added to the individual’s contribution room. Any unused room is carried forward indefinitely to future years, and is reduced by the amount of contributions made. Any withdrawals from the TFSA will be added to an individual’s contribution room in the year following the withdrawal. Note that the increase in contribu-tion room due to withdrawals is not limited to the original amounts deposited to the TFSA, but also includes any growth that has occurred within the account.

Another significant difference between a TFSA and an RRSP is that contributions to a TFSA are made using after-tax dollars while RRSP contributions result in a reduction of income (provided there is available RRSP deduction room). This key difference could drive the investment decision. 

Always speak with a financial advisor to determine what makes the most sense for your financial situation. 
—Trixie Baker
MD Management Ltd.