Picture yourself having $3,000 dollars to invest in the run of a year – where would you park your hard-earned dollars? In an RRSP? A TFSA? Maybe neither? For some, this may seem to be a trivial question, but in reality there are many people who would love to be able to save that kind of cash for retirement purposes, saving for that dream home, a major purchase of some kind, or other purposes.
Whether its families trying to make ends meet, students enrolled in post-secondary education programs, low-income earners, or those who have accumulated debt over the years, the prospect of being able to save two to three thousand dollars isn’t always easily attainable.
On a positive note however, these programs exist, and have been designed and implemented for the average tax payer to take advantage of. If you have to choose one or the other, the correct decision likely depends on your own respective financial situation.
First, here’s a bit of background information of the two programs:
TFSA
Introduced in 2009, the Tax Free Savings Account (TFSA) has been regarded to be a great program by many in the industry. As my trusty CA Personal Tax Planning Guide (2009-2010) informs me, the following is a list of factoids about TFSAs:
- You are eligible to invest in a TFSA if you are Canadian resident who is 18 years of age or older.
- You can contribute a maximum of $5,000 a year into a TFSA. If you have a spouse/partner, you can collectively contribute $10,000 a year.
- You can open an account at any of the leading financial institutions as well as many other institutions.
- You can invest in a wide array of investment vehicles within your TFSA, such as stocks, mutual funds, ETFs, bonds, and GICs to name a few.
- You can carry forward any unused contribution room.
One of the greatest advantages of investing in a TFSA is how it affects you from a tax perspective. It is crucial to know that the “income earned, losses, gains, and withdrawals will not be taxed.” In other words, if you invest say $3,000 in shares of a company that is yielding 7%, and the distributions are paid on a monthly basis, the money you earn (in this case it will be $3,000 x 7% = $210/year = $17.50/month) will not be taxed come tax time. In addition, if the shares of this same stock doubled in value for a total investment value of say $6,000, and you wanted to withdraw the full capital gain of $3,000, you would not be taxed on it come tax season.
What I like about TFSAs in comparison to RRSPs is that I don’t have the feeling that my investments are ‘tied or locked up’. For example, my wife and I bought shares of Liquor Stores Income Fund (LIQ.UN) and Fortis Inc. (FTS) within our TFSAs for the 2009 tax year. If I want to withdraw one of our dividend payments to take my wife out for supper on a special occasion, I can do that with little hassle and on a tax free basis. It’s that simple.
RRSP
Even if you don’t own any RRSPs, chances are you may have heard of them, particularly during the first three months of every calendar year. The RRSP (Registered Retirement Savings Plan) is designed to help the average Canadian save money for the future and for retirement. Once again, by referring to my trusty CA Personal Tax Planning Guide (2009-2010), the following is a list of pertinent details surrounding RRSPs:
- You are generally eligible to contribute up to 18% of your prior year’s earned income (up to a certain limit).
- You can contribute a maximum of $21,000 and $22,000 for the 2009 and 2010 tax years respectively.
- You can open account at any of the leading financial institutions as well as many other institutions.
- Similar to a TFSA, you can invest in a wide array of investment vehicles within your RRSP, such as stocks, mutual funds, ETFs, bonds, and GICs to name a few. In fact, you can even hold gold in an RRSP.
- Once your taxes are filed, keep an eye out in the mail for a copy of your Notice Of Assessment from the Canada Revenue Agency (CRA). This is the form that tells you what your eligible RRSP contribution will be and how much you can invest.
- You can carry forward any unused contribution room, and this can potentially dramatically increase the amount to which you can invest in the run of a year.
The February/March edition of MoneySense magazine has a great article surrounding RRSPs, titled, “Your Top 21 RRSP Questions Answered” and written by Yvetta Fedorova. The article appropriately mentions that a “common misconception is that the RRSP is a type of investment like a mutual fund, but it’s not. It’s simply a saving or investing account with a certain tax-saving characteristic.” I think this is an important fact to keep in mind for any beginner that is looking at investing into RRSPs for the first time.
Investing in RRSPs offers incentives to the tax payer. You may have heard of the concept ‘tax-sheltered’? That’s because when you invest in RRSPs, you are essentially able to save for retirement tax free. You’re not ‘dinged’ on taxes or have to pay any for that matter until you start making withdrawals. From an accountant’s perspective, my trusty guide summarizes this in more professional terminology by mentioning, “the tax benefit of an RRSP is that the RRSP does not pay tax on its income. Thus you can save for retirement tax-free. You will be taxed on the income when it is withdrawn from the RRSP.” A discussion of withdrawing money from your RRSP and some of its advantages and disadvantages is best left for another thread.
The other advantage to the tax payer as it relates to the investing in RRSPs is the immediate tax benefit in the year of the contribution. Depending on your earned income and contribution invested, investing your hard-earned dollars in RRSPs will result in you getting a tax benefit.
If you don’t have to ‘pay in’ come tax season and you have a tax refund, you can invest this money elsewhere upon getting your return. Undoubtedly, RRSPs are often considered to be a strategic investment for many Canadians.
TFSA vs RRSP – Neither
Perhaps you would do neither and invest the money you have in a non-registered account?
The MoneySense article I referred to earlier in this post also appropriately mentions, “The other main benefit of RRSPs is that investments grow inside the plan tax-free. This means you don’t have to pay capital gains when you sell stocks and you don’t have to pay tax when you receive interests in dividends. When you take money out of your RRSP, its taxed as is it was income earned that year.”
The problem however, is that this statement also highlights a disadvantage with RRSPs – the tax man/woman is patiently waiting for you for when you finally decide to make withdrawals. With a non-registered account, despite the fact that you’re being taxed every year on dividend and interest income, you’re able to work on an income stream for the years to come and tweak it to your advantage to minimize the tax burden over time. The investment strategy you use depends on your investments preferences, risk tolerance, etc.
In addition, maybe you would prefer to put those hard-earned dollars towards the principal on your mortgage? I will hold off getting into this subject until later this week as this topic will be discussed at greater length.
Readers – what about you? If you only had $3,000 in the run of a year to invest, where would your park your hard-earned dollars TFSA vs RRSP – and why?
