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You may be using the traditional Registered Retirement Savings Plan (RRSP) route of investing for your retirement. But you should be aware that another powerful tax-efficient investment is available for you to add to the mix—the Tax-Free Savings Account (TFSA).

Remember, RRSP contributions are made with pre-tax dollars, but when you later withdraw that money, it will be taxed as ordinary income. TFSA contributions, however, are made with after-tax dollars; thus eventual withdrawals will be tax free.

The TFSA allows a maximum contribution of up to $5,500 a year. Although a TFSA is very different from an RRSP, each of these accounts holds an after-tax advantage in returns over a non-registered account.

Available for 5 years, TFSAs providing Canadians with $25,500 of accumulated contribution room. The annual contribution room of $5,500 for every Canadian over the age of 18 may not seem spectacular compared to an RRSP, but they do offer growth potential and a considerable tax savings as part of your overall investment strategy.

Combining two unique registered tax plans.

• Those who are 18 years old or over, and are Canadian residents, are able to contribute to a TFSA. If you are eligible to make RRSP contributions, it may be to your advantage to contribute to both an RRSP and a TFSA. If you do not earn income or cannot contribute to an RRSP for any reason, theTFSA offers you a place to contribute $5,500 per annum with the tax-sheltering advantage.
• To illustrate the differences between the TFSA, RRSP, and non-registered savings, let us compare the three according to one scenario. The example used is a $1,000 one-time pre-tax contribution sourced from pre-taxed funds, held for 20 years, by an individual with a 40% marginal tax rate. The conservative return assumed is a compound annual rate of 5.5%.

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Note: The non-registered investment is comprised of a complicated assumption of a tax rate of 28% on investment income in a portfolio that is assumed to be 30% capital gains, 30% Canadian dividends and 40% interest.

What does our mathematical comparison show us?

The RRSP investor quickly gets ahead, benefiting from a tax deduction, leaving this account with the full $1,000 to invest. The TFSA and non-registered accounts, by contrast, start out with only a net $600, with contributions made with after-tax dollars ($1,000 less the 40% taxation unlike the RRSP which enjoys a tax deduction).

The TFSA and the RRSP accounts both accumulate income tax free. The owner of the non-registered account gets hit with income tax each year. After 20 years, the net contribution plus investment income has reached $1,751 for the TFSA, $2,918 for the RRSP, and only $1,307 for the non-registered account.  The math keeps the RRSP in the lead, since it started out with a larger untaxed amount, while the TFSA ranks second and the non-registered account lags.

At the time of withdrawal, the value of the TFSA remains at $1,751, since no taxes are payable on withdrawal of either the original TFSA contribution or any capital gains, dividends, or interest earned.  Comparatively, the $2,918 RRSP is taxable at the highest marginal tax rate at the time of withdrawal, which works out to a tax hit of $1,167. This leaves the RRSP holder with after-tax proceeds of $1,751, thereby finishing equal with the TFSA holder. The non-registered account finishes last with $1,307.

The tax rate at the time of withdrawal, 20 years after the deposit, in this illustration, is equal to that at the time of the contribution. Only when the two rates are identical, as in the hypothetical example cited in above, are the TFSA and the RRSP equally effective as tax-savings alternatives.

When does the RRSP give you the best advantage?

•  The math tells us that those who expect to be taxed at a lower marginal tax rate in retirement should contribute to an RRSP before a TFSA.

•  Most Canadians will spend their employed lives in a higher average tax bracket than theyll have in retirement. Thus, an RRSP may be the best way for the majority of Canadians to build a retirement nest egg.

•  Another RRSP note: If you are planning to buy a home, you can save for your down payment using an RRSP, as you can take advantage of the RRSP Home Buyers Plan; the TFSA does not offer this option though you can withdraw money at any time.

When does the TFSA give me the best advantage?

•  Conversely, if the tax rate at the time of withdrawal is expected to be higher than at the time of contribution, your best choice would be the TFSA.

•  The TFSA would also be a good investment if you are a member of a pension plan and have minimal, if any, room to invest in your RRSP due to a high pension adjustment (PA) factor (more generous plans have a higher PA, leaving less room for personal RRSP contributions). You can supplement your retirement savings through the TFSA.

•  TFSA investments can be a good precaution given the fact that many pensions could face funding deficits as did the Ontario Teachers Pension Plan in 2008 when it had to reduce inflation-indexing to deal with a more than $12 billion deficit (it manages over $100 billion in assets).

•  One should note that every dollar withdrawn from a RRSP or RRIF will reduce the Guaranteed Income Supplement (GIS). The TFSA is not viewed as income nor taken into account when calculating eligibility for GIS, tax credits, Employment Insurance, and so on.

Consider using both the RRSP and the TFSA.

Whether you should contribute to a TFSA or an RRSP depends on whether your working income is taxed at a higher rate than your expected retirement income will be. If your marginal tax rate is higher now, at the time of contribution, an RRSP will likely be your best choice; if the reverse is true, a TFSAis preferable.  But often we are unsure what our tax situation at retirement may look like. In this case, you could try a combination of both accounts; add some money to your RRSP and then use the resulting tax refund to build TFSA savings. If you are an aggressive investor who saves and invests year after year throughout your employed years, you could very well end up in a higher income bracket in retirement. The TFSA offers one the ability to have portfolio flexibility, to juggle between the two investments depending on how things work out over time. It is important not to lose sight of retirement goal-setting or investing in RRSPs and/or TFSAs during market volatility. Using a combination of the two may make a lot of tax sense.

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