For the fourth instalment in our investing basics series (click here to begin the journey) we are going to look at the different account options that are available to you as an investor. I’m sure most of you have heard people talking around tax time about how they should try to, “Buy some RRSPs.” These people don’t realize that what they just said made little sense because no one stops to explain it to them. RRSP actually stands for Registered Retirement Savings Plan. It is not an investment product you can buy. That being said, if you walk into pretty much any bank and tell them you would like to buy some RRSPs they will almost definitely sit you down and promptly lock you into investing in their house mutual fund which pays them an exorbitant fee to invest in a product that you could likely have for much cheaper. This is why you need to know what these weird account acronyms stand for in order to invest your money most effectively.
For the vast majority of people, putting your investments in tax-advantaged accounts is the smartest way to invest your money (we will talk about some other options next time). The principle behind the whole setup of RRSPs, TFSAs and RESPs is that the government wants to encourage you to invest your money. In order to encourage you they will give you cash incentives in the form of tax breaks. If you do not invest your money inside of these protected accounts then it is subject to varying degrees of taxes (we will cover this next time as well) because it is income (just like the income tax that gets taken off your check); however, inside these accounts it is sheltered from taxation to a large degree. This makes a huge difference when you factor in the compounding over a large number of years.
I’ll briefly explain what these accounts all mean and advantages of each:
The Registered Retirement Savings Plan is the most popular tax shelter in Canada, and is meant to help Canadians save effectively for their retirement. Whatever money you invest in RRSPs is tax deductible. This means that when you file your taxes for the year you can get back some of the income tax you paid on your income. Not only that, but anything invested within the plan is allowed to compound and grow tax free. The money is taxed as income when you take it out of the account, but of course when you are retired your income will be fairly low, and consequently it will be taxed at a lower rate. Your tax return from last year will tell you how much contribution room you currently have available in your RRSP.
The Tax Free Savings Account (TFSA) is a rather new addition to the tax shelter stable. It is much more flexible than its RRSP cousin. Investors can take money in and out of these accounts (although this does get a little complicated). Like the RRSP, a TFSA will allow your money to grow tax-free; however, there is no tax deduction that accompanies your contribution. On the flip side, it will not be taxed as income when you withdraw it either. The current limit for a TFSA was set at $5000 per year and indexed to inflation. There has been talk of doubling this limit. Debate has ranged regarding how to best use this account, as well as which tax shelter is best for long term planning. In my opinion, as long as you are saving and investing money, the difference between the TFSA and RRSP is not a big deal. In a perfect world you should max both out (once you’re graduated and making the big bucks that is)!
The Registered Education Savings Plan (RESP) is a personal favourite of mine. I have written about it extensively here at My University Money. The basic idea is that parents can contribute money into a registered account for their child. Any income made on the investments is sheltered just like in the TFSA and RRSP. The contribution is not tax deductible like an RRSP, and taxes are paid when the money is taken out. The great part is that the money is taxed in the hands of the student and not the parents. Since students don’t pay much tax (if any) it is essentially tax-free. The absolute greatest thing about this program is that the government will actually match 20% of your contribution up to $500 per year!! So if you put $2500 into an RESP account the government will kick in another $500. Then you will get to invest with not just your money, but the government’s money too! This is a truly great program that I think every parent should consider.
Remember You Can’t Buy RRSPs
The main thing to remember about all these accounts is that they are not an actual investment vehicle. An RRSP is not something you can buy. It is a type of account or program that you put investments into to get the most out of them. Any of the asset classes we discussed last week can go inside any of the three accounts we discussed. You can put it all into bonds, mutual funds, picking your own stocks, or even good old GICs. Don’t be fooled into doing what your bank wants you to in allowing them to pick your investments for you. Banking professionals are often very good at making options sound appealing and they might or might not be in your best interests, but it will always be in the bank’s best interest.
The advantages of your money growing tax free are massive. We have looked at how quickly compound interest can grow if left to its own devices. If the tax man gets their hand in the whole way it can badly crimp your style! Try to get the maximum out of your investments with proper information and proper planning.
If you are a student or a recently graduated student this can all be a bit much to take in. Try to think of it as something that might pay off a little now, but a lot later. The sooner you learn about investing the better off you are guaranteed to be. Please feel free to comment with any questions or suggestions and we’ll get to them promptly!
Next time we will be taking a closer look at my favourite investing asset class – stocks.