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January is here and you will soon be hearing a lot about Registered Retirement Savings Plans (RRSP's). The deadline for RRSP contributions to reduce your 2010 income is February 29th this year. While RRSP`s are the cornerstone of most retirement plans in Canada, for some, the Tax Free Savings Account (TFSA) may make more sense.

Let's have a quick look at both.

The Registered Retirement Savings Plan (RRSP) was introduced to Canada in 1957 to give Canadians a tax advantaged way to save for retirement. Think of your RRSP as a shopping basket in which you can put such investment products such as stocks, bonds, GIC's and mutual funds where any income or growth from the investments is sheltered from tax. Income earned in an RRSP is not taxable while it remains in the RRSP, including interest, dividends, and capital gains and can grow tax free until the money is withdrawn. When you make a deposit into your RRSP, you will receive a tax deduction for the amount of your deposit. This is actually a tax deferral as you pay tax on the money when you withdraw it. One advantage for many Canadians is that they receive the tax deduction during their working years when they are in a higher tax bracket, and take it out in retirement theoretically when in a lower tax bracket - therefore paying less tax.

Some advantages of an RRSP include:

• Tax sheltered growth
• An immediate tax savings, therefore allowing you to contribute more now.
• Discipline - Since there is a tax consequence for withdrawing the money, you are more likely to use the funds for their intended purpose

Some Disadvantages may be:

• Any funds withdrawn will add to your taxable earnings that year and may be taxed in a higher income tax bracket
• More taxable income in retirement may lead to claw-backs on government programs such as Old Age Security (OAS) or the Guaranteed Income Supplement (GIS)
• Inflexible in that withdrawing funds will trigger taxable income - not a good option for a rainy day fund.
• Limited tax savings at lower income brackets

The Tax Free Savings Account (TFSA) - Each year as of the age of 18, Canadians can contribute $5000 to their TFSA. Any contribution room not used can be carried forward to the next year. As of January of this year, if you were at least 18 in 2009, you would now have $20,000 of TFSA room or $40,000 room for a couple. The TFSA can hold the same type of investments as an RRSP. While you do not receive a tax deduction for contributions, you do not pay any tax when the funds are withdrawn.

Some advantages of a TFSA include:

• Flexibility - Investments can be withdrawn at anytime without any tax consequences and you can replace any withdrawals January 1st of the next year.
• May be suitable for both short and long term objectives (i.e., retirement, short term savings goal or a rainy day fund)
• Since any money withdrawn is not considered taxable income, it may help avoid claw-backs of government benefits in retirement

Some Disadvantages include:

• The name - unfortunately most people think of them as savings accounts only, not necessarily investment accounts
• Limited Room at this point - as of January 1st, each eligible Canadian would have accumulated $20,000 room
• Perhaps TOO easy to take money out - will require discipline to keep the money invested and avoid the temptation to access the funds

So which is the best for you? That depends....

One of the largest determining factors between the two options is your marginal tax rate when contributing verses marginal tax rates when withdrawing. For example, if you are in a 40% tax bracket now and you expect to be in a 20% bracket after you retire, then RRSP's may be better for you. You will get a $4,000 tax refund from a $10,000 contribution now, but only have to pay $2,000 tax in retirement when you withdraw it.

However, there is a common misconception among Canadians that almost everyone will be in a lower tax bracket after they retire. Unfortunately that is not always the case; many Canadians will be in higher tax brackets. One reason for this is the claw-backs on income for seniors. In Canada, we like to provide income for seniors, but then take it away if they have other income. Therefore, seniors with higher taxable income could face reductions in both OAS and GIS.

Another key factor is what you do with the tax refund from your RRSP contributions. If you use the refund to contribute more to your RRSP or pay down debt - advantage may be to an RRSP. If you spend the refund - you may be better off with the TFSA.

Even though there are situations where one strategy is clearly the favourite, in many cases it may make sense to use both - especially if $5000 is not enough contribution room each year to save enough to generate sufficient income in retirement.

If your annual income fluctuates significantly year to year, consider contributing to your TFSA in the years you earn less and contributing to your RRSP in those higher earning years to maximize the tax benefits.

 Speak to your financial advisor before deciding whether to place money in an RRSP or a TFSA or to find out what combination of contributions is best for your particular situation.