UNDERSTANDING HOW YOUR MONEY IS INVESTED IS HALF THE BATTLE
One of the most common questions I hear in my job is ‘what type of account should I be saving in?’
If you are just getting started with investing, then you may have heard about RRSP’s and TFSA’s but not really know the difference between them and when you should be using each one.
That’s what I’m here to talk about today, the pros, the cons, and the best time to use each of these accounts.
When it comes to basic investing you have three main account types you can use; an RRSP, a TFSA, or a non-registered account. Each of these have their own positives and negatives, so it’s helpful to figure out the most valuable for your current situation.
You can hold a variety of investments (stocks, mutual funds, ETF’s, etc.) in any of these accounts; there are a few limitations in RRSP’s and TFSA’s, but unless you are a very high risk, speculative investor, this will likely never come up.
RRSP’s (Registered Retirement Savings Plan)
Since you are here reading a blog about finance, I’m going to assume that you have heard of an RRSP. According to Stats Canada research, approximately 4.2 million Canadians between ages 25 and 54 contributed to an RRSP in 2013. That’s about 28% of the total population in that age group.
So why are so many people investing in RRSP’s?
Well, you might think the main benefit they provide is the tax refund, but the real advantage is that an RRSP allows you to defer tax until a later date (usually in retirement).
What that means is that you can put money in and then not have to pay tax on it until you make a withdrawal.
To make the most of the RRSP, you want to ensure you are making your RRSP contributions when you are in a higher tax bracket than when you withdraw the funds. Let’s say you are earning an income of $40,000 and make an RRSP deposit of $1,000.
This would get you a refund on your taxes of $250 (I’m basing that on the Alberta marginal tax rate of 25%, but it will vary by province). Now let’s jump forward to your retirement and go ahead and withdraw that original $1,000 contribution.
Maybe you are lucky enough to have a pension, and your retirement income is actually $60,000. Your marginal tax rate would then be 30.5% in retirement, and you would have to pay $305 in tax for that withdrawal…so much for that tax advantage!
This is why it makes a lot of sense to delay RRSP contributions until you are in your peak earning years so that you can get the biggest tax break in retirement. There are however a few exceptions.
If your employer provides an RRSP matching plan you will ALWAYS want to take advantage of that; it’s free money in your pocket.
Another time is if you are saving up for your first home. Canada has the First-Time Home Buyers program that allows you to withdraw money from your RRSP tax-free, if that money is to buy your first home.
You do have to pay the money back over the next 15 years but making use of the tax refund you will get can help you hit your down-payment target faster.
You can’t just contribute unlimited amounts of money to an RRSP; you have to earn contribution room by earning employment income.
Each year you will get 18% of your income as RRSP room, up to an annual maximum (for 2017 that maximum is $26,010).
Any unused contribution room will carry-over indefinitely so you can store it up until it makes the most sense to start contributing. To find out how much room you have you can check your notice of assessment or log in to your CRA profile.
TFSA’s (Tax-Free Savings Accounts)
The TFSA was introduced in 2009 and has increased in popularity ever since. Unlike an RRSP, you do not get a tax refund when you contribute to a TFSA.
Your money, however, gets to grow tax-free in the account and you never have to pay tax on it, not even when you withdraw the funds down the road.
Let’s say you invested $10,000 today and it grew to $100,000, you would usually have to pay tax on that $90,000 of growth. If your capital gains tax rate is 18%; that would be a tax bill of $16,200, but if you had made that investment within a TFSA you wouldn’t pay any tax.
Just like an RRSP, government has set limits to how much you can contribute to a TFSA each year. As of 2017, the total contribution is $52,000, but the annual limit has varied over the years.
Here’s the breakdown:
- 2009 to 2012 – $5,000
- 2013 to 2014 – $5,500
- 2015 – $10,000
- 2016 to 2017 – $5,500
To contribute to a TFSA, you have to be Canadian and over 18. If you only turned 18 in 2012, you would not have earned the room from 2009 to 2011. TFSA’s are much more flexible than an RRSP account, and can be used for either short or long-term savings.
There are people you use their TFSA as an emergency fund, to save for a vacation, or as an alternate retirement savings account. These options are all possible because you are allowed to make withdrawals at any time with no tax or penalties.
Another benefit is that you can actually replace the full amount of any withdrawals you make. You do have to wait until the following year, but if you withdraw $15,000 in 2017, you can put that amount back in 2018.
Non-Registered Accounts
Registered accounts, like RRSP’s and TFSA’s, have rules and restrictions established by the government, but there are also non-registered accounts that can provide more flexibility to your investment portfolio.
These can vary from a simple savings account at your bank to an actual investment account held with a brokerage.
There are no limits to how much money you can deposit or what investments are held, but you don’t get the preferential tax treatment you do with either TFSA’s or RRSP’s. Investments in a non-registered account are taxed on an ongoing basis.
Depending out what you hold, you could be looking at tax slips for capital gains, dividend income, or interest. If you are making money on your non-registered investments, you are going to be looking at an annual tax bill.
Takeaways
Deciding which type of account to save in depends on your situation, but there are a couple of guidelines you can follow:
- Investing in an RRSP should be for long-term planning, and you should do it when your current income is higher than what you expect it to be in retirement.
- TFSA’s are similar to non-registered accounts but with better tax treatment. You should always make sure you max out your TFSA before turning to non-registered investments.
Hopefully, that gives you some clarity on the options available for to you for saving money. If you do have any questions, feel free to post them in the comments below.
Post Contribution: Hey everyone, I’m Sarah and I blog about personal finance over at Smile & Conquer and Mr. CBB has been kind enough to open up his blog to me for a guest post. I live in Edmonton, Alberta with my boyfriend, two dogs and two cats. I have blogged for about a year and a half, but I’ve worked my day job in the world of finance for almost a decade.
Photo Credit: Pixabay
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somi says
February 10, 2019 at 6:10 pmWhich option is best if you’re investing in US stocks or ETFs? What about stocks & ETFs outside of Canada & US.
Thank you
jeff says
May 19, 2018 at 7:57 pm“To contribute to a TFSA, you have to be Canadian and over 18…”
Just to make it clear:
You have to be Canadian resident to use TSFA, not Canadian citizen.
…and terms of residency are:
https://www.canada.ca/en/revenue-agency/services/tax/international-non-residents/individuals-leaving-entering-canada-non-residents/non-residents-canada.html
Dan @ Stocktrades says
July 10, 2017 at 12:57 pmHit the nail on the head with this post! I have spoken with a lot of Canadians who are in the lowest tax bracket possible and still contributing to RRSPs. Like you said, it’s probably a good idea if their employer has a matching program but outside of that, you are not gaining very much besides the actual gains on your investments inside the RRSP. With the TFSA being at the point where you can pretty much contribute $100 a week to it, I usually tell them to max this out first, and then contribute to RRSPs. It just makes more sense. Save up that RRSP contribution room for when you are in a higher tax bracket. This has multiple effects, one being you will receive more money back when you file your taxes, and secondly, you will actually have a net gain when you pull it out in retirement.
Leo T. Ly says
July 7, 2017 at 8:50 pmThis is a very informative post Sarah. I think that by knowing the ins and outs of these accounts it will allow people to understand and take advantage of the benefits that these accounts provide.
For me personally, I always maximize my RRSP limit every year, then I would use the tax refund to maximize TFSA. Over a ten year period, these disciplined saving habits resulted in a net worth of over $1M. I would encourage all CBB readers to take advantage of these benefits.
Sarah (Smile & Conquer) says
July 9, 2017 at 11:16 amThanks Leo, I appreciate the comment. That’s a great strategy to make use of both your RRSP and TFSA, and obviously it is working really well for you.