Registered Canadian Investment Vehicles
Investing is a crucial way to create wealth out of money that you do not need at the moment. As a wise man once said, you don’t get rich by working, you get rich by making your money work for you. This proves even more true in retirement, when most people live off of their investments.
So what does it matter where and how someone invests?
It matters because whenever you invest money, as soon as a capital gain is realized or any dividend or interest payment is received, you have to pay tax on it.
In Canada, this is true unless you use an account especially designated by the government for the purposes of saving. The most well known and widely used are the registered retirement savings plan (RRSP), the tax free savings account (TFSA) and the registered education savings plan (RESP).
They all serve a specific purpose:
RRSPs are savings plans meant for retirement. Every Canadian is eligible to contribute to their RRSP until age 71. All of the growth is tax free until it is withdrawn at age 71, when most people will presumably be taxed at a lower rate. Even better, the amount contributed each year is deducted from income, resulting in lower taxes.
The only caveat is that there is a limit to how much that can be contributed each year, which is given to you on your notice of assessment each year after you file your taxes. Careful, because if you over-contribute there is a penalty of 1% a month on the over-contributed amount. (Actually the penalty begins after $2000 over-contribution, but the 2000 is not deductible from income)
There are two exceptions where you can withdraw from your RRSP without paying tax as long as the money is repaid within a specific amount of time. These are for first time home-buyers to make a down payment for a first home, under the Home Buyer’s Plan and for adult education costs under the Lifelong Learning Plan.
Another important thing to know about is a spousal RRSP. This is usually used when the income of one spouse is much higher than the other. In this case the spousal RRSP is registered in the name of the lower income spouse, while the higher income spouse can contribute to it. As a result, the higher income spouse can deduct the contribution from his/her income, and when withdrawn it will be taxed in the hand of the lower income spouse.
TFSAs are lifetime savings plans. They are not specifically meant for retirement, but are meant to be a savings vehicle throughout one’s lifetime in case one ever needs emergency cash or to make a down payment on a big purchase.
It is completely tax free even when withdrawn, unlike the other two plans. However unlike RRSPs, it cannot reduce income and taxes. TFSA contributions are limited by a standard amount for all Canadians announced each year. For 2019 the amount will be $6000 while in 2018 it was $5,500. If unused, amounts from one year can be used the next year. As is the case for RRSPs, if you over-contribute there is a penalty of 1% a month on the over-contributed amount.
You have the right as a Canadian to invest money and make tax free income so why not take advantage?
RESPs are meant for parents to save up money for their kids, allowing it to grow tax free until their kid attends post secondary school.
When finally withdrawn the growth will be taxed in the hands of the child not the parent which means major tax savings on income growth. The capital which goes back to the parents is not taxed. There is a lifetime limit per beneficiary of $50,000 which if exceeded results in a 1% a month penalty like the above two savings plans.
This is a great way for parents to put aside money, forget about it for 18 years, and then when confronted by the kids for university tuition suddenly be pleasantly surprised by that money kept aside plus growth.
Bottom line? It’s a great idea to invest money that you don’t need right now and it’s even smarter to not pay taxes on that money.