Is it better to open a TFSA or RRSP first? Here's your answer

Feb 5 2023, 6:00 pm

The Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) are two of the most popular investment vehicles available to Canadians.

Both types of registered accounts allow for tax-advantaged growth and can be used to hold cash savings as well as investments like stocks and bonds.

Below, we’ll go over some of the basics of each account and explain the best one to open first so that you can meet your savings and investment goals.

RRSP vs TFSA: The basics

Two piggy banks side-by-side, one printed with “TFSA,” the other with “RRSP.” A question mark is between the two.

DD Images/Shutterstock

The RRSP is the most popular type of retirement-specific savings account in Canada, and most major banks offer RRSP accounts to their customers. This year, 51% of Canadians plan to contribute to an RRSP, according to a report by Edward Jones.

RRSPs are primarily used as investment vehicles for retirement. RRSP contributions are tax-deferred, which means that your contributions are income-tax deductible.

That being said, your post-retirement withdrawals are subject to standard income taxes. Early withdrawals may also be subject to tax penalties.

TFSAs aren’t specifically designed for retirement savings, but many (myself included) use them for retirement purposes. The TFSA is more flexible than the RRSP and is designed to help people reach both short and long-term savings goals, be it a down payment on a house, saving up for your first car, or even just a simple emergency savings account.

Contributions made to a TFSA are not income-tax deductible, meaning they’re made using post-tax income.

However, profits realized from your TFSA investments aren’t subject to any tax (as they are with traditional non-registered investment accounts), and you won’t pay income tax on any withdrawals from the account.

The CRA places annual contribution limits on both RRSPs and TFSAs. Over-contributing to either type of account can result in tax penalties. Both accounts can also be used as investment vehicles, and you can have more than one of each.

Here’s a table outlining the key similarities and differences between RRSP and TFSA accounts:

RRSP TFSA
Primarily used for retirement savings Can be used for retirement savings as well as for short-term savings goals
Can hold cash and investments Can hold cash and investments
CRA imposes an annual contribution limit CRA imposes an annual contribution limit
Contributions are income-tax deductible Contributions are not income-tax deductible
Early withdrawals may incur a tax penalty No penalty for early withdrawals
Post-retirement withdrawals are taxable No taxes upon withdrawal
If you pass away, your RRSP will be taxed before funds are issued to your beneficiary If you pass away, your beneficiary may receive your TFSA tax-free

Should you open a TFSA or an RRSP first?

Contributing to a TFSA or RRSP is a far better idea than holding your money in a traditional bank savings account, where it will likely earn less than 0.5% interest each year. Both of these registered accounts may be used to hold investments that can grow over time and offer opportunities for tax-advantaged growth.

Reasons you should maximize your TFSA first

Of the two, however, I believe that the majority of Canadians will benefit more by opening a TFSA and maximizing their contribution room before investing in an RRSP.

Here’s why:

More tax flexibility

TFSA contributions are made with after-tax dollars, meaning you’ve already paid taxes on the money you contribute. In contrast, RRSP contributions are made with pre-tax dollars, which are taxable when you withdraw them in retirement.

By prioritizing TFSA contributions, you maintain tax flexibility and can access your savings without triggering additional taxes, which can make financial planning easier.

TFSAs can serve as an emergency fund

TFSA contributions can serve as a versatile emergency fund. You can withdraw your funds at any time without penalties or taxes, providing a financial safety net for unexpected expenses.

Conversely, early RRSP withdrawals are taxable, even for emergency situations.

TFSAs can accommodate both short-term and long-term goals

While TFSAs may be used for retirement savings, they’re a lot more versatile and can help you reach your long-term and short-term savings goals. You can withdraw from your TFSA at any time without going through the hoops and hurdles of early RRSP withdrawal.

May help you qualify for income-tested retirement benefits

Some government retirement benefits, such as the Guaranteed Income Supplement (GIS) and Old Age Security (OAS) for seniors, are income-tested. Your benefits may be reduced if your RRSP withdrawals exceed a certain amount. TFSA withdrawals, however, will not affect your benefit eligibility.

By minimizing RRSP withdrawals in retirement, you can potentially qualify for these benefits and credits, making your TFSA withdrawals a more valuable income source.

Better for estate planning

Lastly, TFSAs make estate planning significantly easier, allowing you to leave more behind for your loved ones. Funds from your TFSA may be immediately entrusted to a beneficiary who can receive the full amount tax-free.

With an RRSP, the CRA would take its share of income taxes before passing the remainder to your chosen beneficiary.

Why you might want to consider investing in an RRSP

While I usually recommend readers to open a TFSA before an RRSP, there are a few circumstances where opening an RRSP can be particularly beneficial.

You’re in a higher-income tax bracket

If you’re in a higher-income tax bracket, you’ll want to take advantage of every deduction available to reduce your tax liability. As long as you remain within your contribution room, all RRSP contributions are tax-deductible from your income, which could help you save a lot on taxes.

Your employer matches RRSP contributions

Some employers may offer to match a percentage of your RRSP contributions, which is essentially free money. If the amount your employer offers is significant, I would strongly consider contributing as much as you can to your RRSP while you’re with the employer.

Planning for retirement

While RRSPs can be an excellent long-term investment vehicle to help you save for retirement, TFSAs are a more practical choice overall. TFSAs offer unlimited potential for tax-free growth, and you won’t be penalized for early withdrawals, making them a flexible choice for both retirement savings and short-term goals.

That being said, if you’ve already maximized your TFSA contribution room and you’re looking for more ways to save money and pay less taxes, opening an RRSP can be a great step to take next.

Written for Daily Hive by Christopher Liew, a CFA Charterholder, former financial advisor, and the creator of Wealth Awesome.

Christopher LiewChristopher Liew

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