This post is for all of you who want to start your journey towards financial independence. I recommend you start here before you read other articles about investing. Foundation is key! Once you understand the basic features of these two common accounts, you will be well on your way to determine how you would like to reach financial freedom.
RRSPs vs. TFSAs
The Registered Retirement Savings Plan (“RRSP) and the Tax-Free Savings Account (“TFSA”) are the most common accounts for long-term savings, i.e. retirement. The biggest misconception is that you can “invest” in an RRSP or a TFSA. You cannot.
I think a more accurate term is “briefcase” rather than "account," since both a RRSP "briefcase" and a TFSA "briefcase" really just hold your money. Both briefcases have unique tax saving benefits. Since they operate differently, ideally you would have both briefcases and max out the contributions in both.
Although you could technically just leave your money sitting in these briefcases, this is discouraged. For the average individual, this amount will not be enough to reach financial freedom. Your money will need to grow. Although it seems scary, this can be done through investing your money sitting in those briefcases, in a way that best suits your risk level.
The RRSP Briefcase
Let’s first look at the RRSP briefcase.
Every year, you can contribute up to 18% of your annual income into this briefcase. This can be done as easily as signing up for an RRSP briefcase at the bank of your choice. If you use online banking, you’ll see this briefcase listed there shortly after you sign up. You can easily move your money into this briefcase through automatic transfers.
I also mentioned that this briefcase comes with special powers. Well, when you contribute money into your RRSP briefcase, the money is technically after tax earnings. But when you file your taxes for that year, it is mandatory for you to report the amount you contributed into your RRSP briefcase. After the CRA calculates everything, the CRA will then send you a tax refund – which includes the amount of tax you paid on the money you funnelled into your RRSP briefcase.
With great powers also comes great responsibilities (yeah, I just went there).
If you want to withdraw money from your briefcase before you retire, you will pay a “withholding tax.” Based on the amount you withdraw, you will be taxed a certain percentage:
- If you withdraw up to $5,000, you'll incur a withholding tax of 10%
- If you withdraw between $5,000 - $15,000, you'll incur a withholding tax of 20%
- If you withdraw $15,000+, you'll incur a withholding tax of 30%
Another downside of dipping into your briefcase before retirement is that you’ll have to include that amount you withdrew as taxable income when you file your income tax. You might be potentially paying even more tax!
Finally, once you withdraw money before retirement, that contribution room is lost. Plus, all the compound interest that was growing on the initial amount you withdrew is now lost.
There are, however, two scenarios where you can withdraw money from the briefcase without paying withholding tax:
- 1) if that money goes towards buying your first home
- 2) if that money goes towards education or training. Let’s look at both scenarios.
The first scenario is actually named the Home Buyers’ Plan (HBP). Under the HBP, you and your partner can borrow up to $25,000 each ($50,000 total) for a down payment on your first home. You won’t be subject to the withholding tax, so long as you pay that money back into your briefcase over the next 15 years. If you aren’t able to replace that money after the 15th year, you will be taxed.
The second scenario is titled the Lifelong Learning Plan (LLP). Under the LLP, you and your partner can each borrow up to $20,000 from your RRSPs to pay for full-time or part-time education or training expenses. However, you can’t take out more than $10,000 per year. Similar to the HBP, you won’t be subjected to the withholding tax, so long as you repay that money back into the briefcase over the next 10 years.
The TFSA Briefcase
Now let’s look at the TFSA briefcase.
The TFSA briefcase is newer and shinier than the gently-worn RRSP briefcase. You can open up an TFSA briefcase as soon as you turn 18 years old. Similar to the RRSP briefcase, you can sign up for a TFSA briefcase at your bank of choice. You can also use online banking and deposit money into your TFSA briefcase just like the RRSP briefcase.
Let's look at some of the unique features of the TFSA briefcase.
Currently, the annual contribution limit is $5,500. Unused contribution room can be carried forward indefinitely. So, if you didn't max out your annual limit in the past three years, that total amount will get added to this year's contribution limit. You can check your contribution room if you signed up for a CRA online account (it may not always be accurate though, so you may have to double-check with them).
You can use your TFSA briefcase to save for any goal. It does not need to necessarily be for retirement. For example, some people prefer to stash their savings for a wedding, new car or a down payment in a TFSA briefcase. Why? You can withdraw your money at any time without being subjected to a withholding tax! If you withdraw $500, you're getting $500 tax-free. Also, all investment returns that you earn in your TFSA briefcase are not taxed either.
Why are you allowed to do this? Because although you’re contributing after tax money like you do with the RRSP briefcase, you won’t receive an annual tax refund for the money you contributed.
So, while not receiving that extra cash every April may suck, the TFSA briefcase makes up for it with its flexibility. You can withdraw your money at any time, without penalty. Another bonus is that your future contribution room won't be affected. For example, if you withdraw $3,000 in 2017, you can re-contribute $3,000 in 2018 without affecting your 2018 contribution room.
Another important difference is that any income or withdrawals from a TFSA briefcase will not affect your eligibility for federal tax credits or income-tested benefits, i.e. Old Age Security, Guaranteed Income Supplement (GIS) and the Canadian Child Tax Benefit. When you withdraw money from your RRSP briefcase when you retire, that money is considered taxable income and may affect your eligibility for some of these government credits.
The TFSA briefcase tends to be popular for twenty and thirty-somethings, since they tend to have more variable income and require easier access to liquid cash in emergencies.
I Have My Money in a RRSP Briefcase and/or a TFSA Briefcase, Now What?
Congratulations! That’s the first step. Now here comes the fun! You get to decide where you want to invest your money. Think of it like a Goosebumps book where you can choose your own journey, except one doesn't lead to.. death.