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What you need to know about tax-sheltered savings accounts

You’ve heard of savings accounts offered by banks. In fact, you may even have one or two. Banks pay interest on the money you deposit in your account, which over time means your balance will grow.

But there’s another kind of savings account you’ll want to know about. As you start to make money, you’ll hopefully have funds left over after covering your living expenses. You can use some of these funds to start investing. And if you take advantage of government-sanctioned accounts, you can shelter some of your gains from taxes.

There are two main tax-sheltered accounts in Canada: Registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs). These vehicles are designed to allow Canadians to maximize their savings. RRSPs, as the name suggests, are geared for retirement savings. TFSAs can also be used to save for retirement, but may also be employed for general savings purposes (such as a new car or house).

RRSPs and TFSAs are similar but there are some important differences. In the case of RRSPs, Canadians over the age of 18 may contribute 18% of their earned income (i.e. salary or wages), up to a specified maximum amount (whichever number is less). In 2016, this figure is $25,370. Individuals can then deduct this contribution from their taxable income in a given year, which reduces the amount of taxes they have to pay. And unused contribution room continues to accumulate until age 71.

In addition, when you make money on an investment held in your RRSP, you won’t incur any taxes so long as the money is held in the RRSP. This allows Canadians to accumulate substantial savings until such time as they actually retire and need the money.

However, in the age you turn 71 (which is decades away), an RRSP must be either closed or converted into something called a registered retirement income fund (RRIF). Long story short, when you no longer have your RRSP, you’ll start to pay taxes on the money you withdraw from the account. However, you can make tax-free withdrawals of up to $25,000 to buy a house under the Home Buyers’ Plan (HBP) or up to $20,000 to further your education under the Lifelong Learning Plan (LLP).

In contrast to RRSPs, TFSAs permit you to save and invest significant amounts of money every year tax-free, forever. Currently you can contribute up to $5,500.

Importantly, even if you don’t contribute the full amount in one year, you can carry over that “room” in your TFSA for future years. For example, someone who was 18 or over when TFSAs were introduced in 2009 would have total contribution room of $46,500. Contributions aren’t tax-deductible as with RRSPs, but you can withdraw money from a TFSA at any time without having to pay tax. And it gets better because in subsequent years you can then re-contribute the money you took out. With RRSPs, you can’t unless re-contribute what you withdrew unless it was for the HBP or LLP.

People often confuse RRSPs/TFSAs as merely savings accounts (like what you’d have at a bank). While you can put cash in an RRSP just like a savings account, you’ll probably want to consider other options. Given that your savings grow tax-free, you might as well include some investments that will earn you more than a savings account (which these days don’t pay very much in interest).

So what can you buy? For both RRSPs and TFSAs, there are actually a large number of options. Guaranteed investment certificates (GICs) are a safe way to earn a better return on your money. With GICs, you get a certain rate and are guaranteed not to lose money. Most Canadians have exposure to as well as equities in these types of savings vehicles. Fixed-income refers to anything that is technically a debt instrument. It can be a Guaranteed Investment Certificate, it could be a corporate bond, or it could be a government savings bonds. With all these investments, the individual lends their money to a bank, company or government and is paid some interest, plus their money back, in return.

Stocks and bonds are other options. When you buy a stock, you’re buying a piece of a company. And when you buy a bond, you’re buying a piece of a company’s (or country’s) debt.

The easiest way to do this is by purchasing a mutual fund or index fund (a cheaper version of a mutual fund) through a bank. We prefer index funds since the management fees are much lower than mutual funds and saving money’s important.

Making the right investments is obviously important, as is keeping your portfolio well-diversified. But another key to being a good investor is taking advantage of tax-sheltered savings accounts. If you’re starting to make money, make sure you open up an RRSP and TFSA and let the tax-free investing begin.

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Topic: 
money, savings, finance