TFSAs, RRSPs or both?

For years, Duncan MacAdams socked away money in his registered retirement savings plan. At 68, the Halifax property manager has accumulated a nest egg of about $100,000.

But when the tax-free savings account came along last year, he stopped contributing to his RRSP and maxed out his TFSA instead. The reason? Because he doesn't make a large income, the TFSA is more advantageous for him, he says.

"RRSPs are useless until you get into a pretty impressive income bracket," he says. What's more, "with the RRSP you get taxed on the way out. With the TFSA you don't."

With the March 1 RRSP contribution deadline looming and the TFSA growing in popularity, many Canadians - particularly those with limited funds to invest - are struggling with the same question: Should I add to my RRSP, or plunk my money into a TFSA?

The answer is complex, but it comes down to taxes - specifically the difference between your current tax rate and your expected tax rate when you withdraw your money.

If you expect your future tax rate to be the same as your current tax rate, then there is effectively no difference between an RRSP or TFSA, assuming the same rate of investment returns for each.

If you expect your future tax rate to be lower than it is today, however, then the RRSP is the better option, because you'll be deferring income tax until you're in a lower bracket.

On the other hand, if you expect your future tax rate to be higher, then the TFSA is the clear winner, because withdrawals from a TFSA are not subject to income tax.

The problem is, predicting future tax rates can be a challenge.

. Weigh in on whether you would stash some extra money into an RRSP, RESP or a TFSA.

Most people are convinced that their tax rate in retirement will be lower because they will have a reduced income, which makes RRSPs seem like a no-brainer. But it doesn't always work out that way, says Camillo Lento, lecturer in accounting at Lakehead University.

In fact, many people will face a higher effective tax rate in retirement, once the impact of income-based benefit clawbacks is taken into account.

Consider a senior with an income of $70,000 and a marginal tax rate of 33 per cent. Each additional dollar withdrawn from an RRSP (or from a registered retirement income fund or RRIF) would be taxed at 33 per cent. But a portion of that dollar - 15 per cent - would also be lost to a clawback of Old Age Security (OAS) benefits. In addition, the senior would face a 2.25-per-cent reduction in the federal age credit amount, for a total effective tax rate of 50.25 per cent.

"When you pull money out of an RRSP all of these clawbacks really impact your tax rate at retirement. So your tax rate is actually quite high," Mr. Lento says.

Seniors at the low end of the income scale are taxed at an even higher rate when clawbacks are included.

Based on 2009 data for Ontario residents, a senior with an income of $10,101 to $15,600 would face an effective tax rate of 71 per cent on RRSP withdrawals, according to Mr. Lento's calculations. That's largely because of the 50-per-cent clawback of the Guaranteed Income Supplement (GIS), a government benefit geared to low-income seniors.

People expecting a low income in retirement are therefore better off contributing to a TFSA, because the withdrawals are not included in income and don't result in a GIS clawback.

In other cases, RRSPs provide more bang for the retirement buck.

The sweet spot for RRSP withdrawals is when retirement income is between $15,672 (the point at which GIS is reduced to zero and no further GIS clawbacks occur) and $66,335 (the threshold at which OAS benefits start getting clawed back). For seniors in this income bracket, the effective tax rate on RRSP withdrawals ranges from 21 per cent to 33.25 per cent, making the RRSP an attractive option assuming the person paid tax at a higher rate when they were employed.

One way to avoid hefty taxes on RRSP withdrawals is to retire early and start depleting your RRSP before your corporate pension and government benefits kick in, Mr. Lento says. By drawing down your RRSP when you have little or no other income, you'll be taxed at a lower marginal rate, and your withdrawals won't result in clawbacks of government benefits.

Determining whether a TFSA or RRSP is your best option is a complex exercise that depends on many variables, some of which are hard to predict. Malcolm Hamilton, a pension consultant with Mercer (Canada) Ltd., says the important thing is to pick one - or both, if you have the funds - and make a contribution.

There are cases where one savings vehicle is clearly superior to another, but for many people it may not make a huge difference in the long run. So the important thing is to make a decision and get on with it.

"The tragedy here is if they just freeze up and procrastinate and can't make a decision and decide to do neither," Mr. Hamilton says. "So just do the one you feel most comfortable with and don't really worry about it."

Here's how they stack up: