Tax-Sheltered Accounts: What they are and Why you NEED them.

One big mistake I have made with my finances is failing to make regular contributions to my registered accounts. When I finally got my act together, I was shocked to see how much contribution room I had in both my RRSP (Registered Retirement Savings Plan) and my TFSA (Tax-Free Savings Plan). I was even more shocked when I understood the benefits they provide and what I had been missing out on all this while.

Dear friends, I don’t want you to make the same mistake I did, so allow me to explain what these accounts mean and how you can use them.

Registered accounts exist to encourage Canadians to “save money” by providing the incentive of tax-sheltering (i.e. “covering” money from being taxed by the government).

Whether you’re putting money away for retirement in the case of the RRSP or using your TFSA for other short term/long-term plans (e.g. a wedding, car, vacation), the government provides tax-sheltering when you save money using these accounts.

Although these accounts are called SAVINGS accounts, I think this really undervalues the important role they can play in your financial well-being. These accounts should actually be called INVESTMENT accounts and I will tell you why.

TFSA – Tax-Free Savings Account

The TFSA was introduced by the Canadian government in 2009 and is available to all Canadians over the age of 18 with a valid Social Insurance Number.

Every year, there is a contribution LIMIT. If you do not reach your limit for a particular year, the amount is carried forward to the next.

For example, because I have not been contributing to my TFSA regularly, even though the limit for 2020 is just $6,000, I have about $64,000 of unused contribution room that has been accumulating. This hurts because I could have been investing at least some of that amount over the years!

Basic TFSA Rules

Do deposit as much as you can.

Do not contribute beyond your total limit because there is a penalty if you do.

Do invest this money in a vehicle that will bring you good returns because… THE MONEY EARNED IS TAX-FREE.*

To illustrate, let’s say you deposited $6,000 to your TFSA account in January 2018. You then placed this money in an investment vehicle that gives a return of 7% per year. Two years later, in January 2020, your money would have grown to $6,869.40. That’s $869.40 of interest. If you had earned that money working, the government would have taken its cut. But because it is earned through a TFSA, it is sheltered from tax and that interest is all yours!

Now if you decided to just park that money in your TFSA instead of investing it, then inflation will eat away at it and your money will lose its value. I explain the concept of inflation here.

You can withdraw from your TFSA anytime you want. This contribution room becomes available again the following year.

RRSP – Registered Retirement Savings Plan

The RRSP was introduced by the Canadian government in 1957. It is available to all Canadians with a valid Social Insurance Number when they start earning income.

The contribution LIMIT each year is either 18% of your income from the previous year or a set maximum amount ($27,230 for 2020). If you contribute to a pension plan, the amount will be deducted from your RRSP limit. Unused contribution room is also carried forward hence why I have unused contribution room of over $140,000 in my RRSP! (Please don’t be like me friends!)

Unlike the TFSA, simply making a deposit into your RRSP has a tax benefit: You are able to deduct the amount contributed from your taxable income.

As an example, if your income was $80,000 in 2019 and you also deposited $6,000 to your RRSP, you can claim this as a deduction when you file your taxes. Your TAXABLE income drops to $74,000. Assuming you are in the 20% income bracket, that means you will save $1200 in taxes!

See why I’m so upset at myself?! I’ve been breaking the cardinal rule of wealth-building… all this while I’ve been paying the government before paying myself. Ugh!!

Basic RRSP Rules

Do deposit as much as you can.

Do not contribute beyond your total limit. There is a little wiggle room of $2,000 but if you contribute above that, you will be charged a penalty.

Do find out if your employer matches your contribution. If they do, then take advantage of this.

Do invest this money in a vehicle that will bring good returns. The money earned will not be taxed… UNTIL you eventually withdraw. This is called “tax-deferral”.

Do dissolve your RRSP by age 71. For more information click here.

The TWO situations when you can BORROW from your RRSP before retirement are:

1. Home Buyer’s Plan
2. Lifelong Learning Plan

This borrowed money is not taxed, but has to be paid back to the RRSP. Outside of these two reasons, what you withdraw from the RRSP will be taxed according to your current income bracket. So try not to withdraw before retirement.

Retirement = Less income than working years = Lower tax bracket

In addition, anytime you take money from your RRSP, you lose the contribution room equivalent to the amount withdrawn, permanently.

In summary, the purpose of these two registered accounts is to minimize lifetime taxes paid, and maximize income available during retirement.

Do you need both a TFSA and an RRSP? If you are able to max out both accounts then go for it! As long as you pick good investments, having these registered accounts will serve you well.

Otherwise, fund the one that benefits YOUR particular situation first, and fund the other one at a later date. You can always go back and forth with investing between the two, as your situation changes.

As an example, if your taxable income is low this year because of maternity leave, you may choose to contribute to your TFSA and save your RRSP contribution room for next year, when you are back to work. Why? Because contributing to your RRSP when you are earning more will help reduce your taxable income.

So that was A LOT of information! Hopefully it makes sense and I’m not missing any details. If I am, please feel free to add in the comments below. I’d also like to hear how you feel about these registered accounts. Which do you prefer at the moment? Does one suit your life right now more than the other?

Love,

Addendum

*If you invest in American dividend-paying stocks, The United States IRS does collect a 15% withholding tax from Canadians, even though the TFSA is supposed to be Tax-Free (rolling my eyes). This withholding tax does not apply to American dividend-paying stocks held in an RRSP.

To check your TFSA and RRSP contribution room, login “My Account” on the CRA website here.