Registered Savings Accounts

Before I start talking about registered savings accounts, I want to re-iterate a previous point I made in one of the first posts. Saving for retirement (and saving in general) is not a luxury, an option, for boring people, etc. Saving is absolutely essential and mandatory. I cannot understate its importance. If there is anything you can learn from this post, and any of my posts on this blog, it's that developing, maintaining and continually evaluating a savings plan is perhaps the best and most important personal financial decision you can ever make.

There’s an old adage that says there are only two things in life that are certain: death and taxes. Taxes are not only certain, but momentous difference-makers regarding personal finance. Nothing affects your portfolio more than taxes, which makes tax strategising that much more crucial for the health of your investments. RRSPs, TFSAs, and RESPs are investment vehicles set up by the Canadian government to benefit taxpayers in accumulating wealth. Used the right way, they can be remarkably beneficial to accumulating your wealth. Understanding how they work are therefore essential.

What are RRSPS, TFSAs, and RESPs?

RRSP stands for registered retired savings plan. Basically, the Canadian government allows you to take a percentage of your earned income each year and store it in a specialized bank account, where it is allowed to grow tax free. In other words, over the years that it is earning interest, investment, or dividend income, it is not taxed at all; hence, it grows at a faster rate. The idea behind RRSPs is that after the age of retirement, you can convert your RRSP to an RRIF, which is the inverse of an RRSP – you have to withdraw a certain percentage of the account every year, presumably for retirement income. The RRIF is a retirement income fund – it funds your retirement.

The maximum amount you can contribute to your RRSP account on a yearly basis is 18% of your earned income (from the previous year), up to a maximum of $22,000 annually (for year 2010). Whatever amount you do contribute can be used as an income tax deduction for that year (to be explained later). As well, if you don’t contribute in any one year, that amount is carry-forwarded to the following year. For instance, if in 2008, your earned income was $50,000, your RRSP contribution limit is about $9,000 (50,000*18%). If you did not contribute anything in 2008, and then your income was $50,000 again in 2009, you can contribute up to $18,000 in 2010 ($9,000 for the carry-forwarded amount from 2008, and another $9000 for 2009).

How do you know how much you can contribute in any given year? Look at your notice of assessment. Every year, after you file your tax return, the government sends back a document confirming your net income and taxes payable. This document often includes your tax refund (if you qualified for it). That document states the allowable RRSP contribution limit for the following year. The document also automatically adds up previous years’ unused contribution amounts, so you are up to date with today’s contribution limit. So don’t throw it out!

It is important to note that an RRSP is not a tax-free account; it is a tax-deferred account. When you withdraw money out of your RRSP, you will be taxed at your regular income tax rate, even if you are passed the age of retirement. Why then would invest in RRSPs in the first place – in other words, what difference does it make? There are at least 4 reasons (that I can think of) for utilizing an RRSP account:

a) Over time, investments that grow tax free will become sufficiently larger than a comparable taxed account, so that even after you pay your taxes upon withdrawal, you will still end up with more money.

b) Presumably, your tax rate will be higher when you are earning a salary than when you are retired. If you are now earning $200,000/year, your marginal tax rate will be approximately 45%. But when you are retired, you probably will be earning between $50,000 - 100,000 (obviously every situation is different) which is a much lower tax bracket. So it can make sense to defer taxes until a later time, when you are in a lower tax bracket.

c) For any undisciplined savers: Once you put your money into an RRSP, you will incur heavy penalties for withdrawing it early. Therefore, RRSPs can be a deterrent for spending away your savings on the newest fashions, cars, gadgets, etc.!

d) There are ways to manipulate your RRSPs in later years to avoid certain taxes, such as buying an annuity. Speak to your financial advisor.

This makes RRSP strategising crucial. For instance, if you are only earning $30,000/year now, but you expect your income to jump to $100,000 within the next five years, it may be better to defer your RRSP contribution room to when you are paying a higher tax rate. More on these concepts next post.

What happens if you need to withdraw funds from your RRSP early?

If you withdraw early, you will incur withholding taxes on the amount of the withdrawal. The 2010 withholding tax rates are as follows:
Up to $5000: 10%
$5000 – $15,000: 20%
Over $15,000: 30%

However, you will end up paying the difference between your marginal tax rates (in the year of withdrawal) and the withholding tax rate. So, if your marginal rate is higher than 30%, you will pay the difference anyways. Furthermore, if you do withdraw early, that contribution room is lost forever. You cannot replace the RRSP withdrawal the following year – you have to wait until you’ve earned new contribution room.

Yikes! In other words, the government really, really doesn’t want you to withdraw your RRSP investments early. However, there is one major exception to this rule, which especially applies to younger couples. The Home Buyers Plan allows you to withdraw up to $25,000 from your RRSP to purchase a (first-time) home (for each spouse if applicable). This amount is essentially borrowed from your RRSP – you owe the $20,000 back to your RRSP over the next 15 years, or that amount will become taxable in the year that the 15 year-term expires. There are many rules regarding the HBP – check them out at http://www.rrsp.org/hbpguide.pdf. You can also withdraw funds from your RRSP to pay for your education, or your spouse’s education (not for your children!). To see the rules regarding that, see http://www.tninsurance.ca/lifelong.htm.

RRSPs are often complicated, and you should do your research before investing in them. However, RRSPs are extremely valuable tools that at least should be considered by everyone, so do your research!

What about TFSA’s?
A TFSA is a tax free saving account. The TFSA was first introduced in 2009 by the Canadian government, in response to the remarkably low savings rates that Canadians were employing. A TFSA allows you to contribute up to $5,000/year to a specialized bank account, in which savings grow tax-free. Just like with RRSPs, unused contribution room is carry-forwarded to following years. However, unlike RRSP’s, TFSA withdrawals can be made up – in other words, if you withdraw from a TFSA in 2010, you can re-contribute the withdrawal amount in 2011. You can withdraw money from your TFSA at any time, and avoid taxes completely upon withdrawal.
TFSAs are the only true tax-free savings account (as opposed to a tax-deferral account). In my opinion, TFSAs are a nicely wrapped gift from the Canadian government and should be utilized by practically everyone.

What’s the major, crucial difference between an RRSP and a TFSA? RRSPs are pre-tax contributions – you get to deduct the amount of the contribution from your net income in the year of the contribution. TFSAs are after-tax contributions – your contributions have already been taxed as regular income. In other words, it’s not the contribution that is tax free; it’s the growth on contributions that is tax-free.

Recent reports have shown that only 20-30% of Canadians have been utilizing TFSA’s, which really astounds me. In my opinion, practically every tax-filer should utilize their TFSA contribution room. There are reasons when it’s appropriate not to, but it’s more because you don’t have the money to contribute to them (after contributing your savings to other accounts). If you have a pile of cash/investments sitting in the bank that are not registered, nor have the ability to be registered, why wouldn’t you put them in a TFSA?

I will defer a discussion on RESPs for a later time.

So now you understand what TFSAs and RRSPs are. Should you contribute? How much to contribute? Which account to contribute to? What should I invest in?

These questions and others will all be discussed in next week’s post!