Understanding Registered Accounts

Registered Accounts:
What they are, How they work, When to invest in them

Tax-free, tax-deferred, tax-sheltered, group plans, RRSP, TFSA, RESP, RRIF and the list goes on. With so many different types of accounts and confusing acronyms, trying to navigate the options and put together a strategy that makes sense for you can seem like an overwhelming task. With RRSP season in full swing, I thought it would be a good idea to break-down the top registered account types. What they are, how they work and when to invest in them.

Registered Retirement Savings Plan (RRSP)

RRSPs have two main benefits: 1) The money you put in each year is tax deductible and 2) any growth or income you receive is allowed to compound tax-sheltered.

Because your contribution works as a tax deduction, it lowers your taxable income. Here’s a simplified example of how this works. Say you made $100,000 and your employer withheld the appropriate amount of tax on your pay. If you make a $10,000 RRSP contribution, it reduces your taxable income from $100,000 to $90,000. The difference between whatever tax would be payable on $90,000 and the amount of tax that was withheld on the $100,000 will come back to you in the form of a tax refund.

In addition to the tax savings upfront, the other major benefit of an RRSP is tax-sheltered growth. Because you’re not paying any tax on the income or growth, your wealth will grow a lot quicker as compared to holding investments in a non-registered investment account where you have to pay taxes along the way. The 2019 RRSP contribution limit is 18% of your earned income from last year (2018) up to max of $26,500. And the great thing about an RRSP is that the contribution room is carried forward, so if you are unable to contribute the full amount in any given year, it accumulates.

It’s important to note that an RRSP does not provide a permanent shelter from taxation, but rather defers income tax payable until a future date. What that means is that at some point in time you will withdraw money from it. And when money is withdrawn from the plan it will be included as taxable income of the plan holder. However, since this is a retirement fund, your taxable income will likely be much lower when you do begin to withdraw funds from the account.

Registered Retirement Income Fund (RRIF)

A RRIF is created from the assets of an RRSP. Although you can open one earlier, you are required to close your RRSP by the end of the year you turn 71. Although there are other things you can do with the money in an RRSP, like cash it all out or convert it into an annuity, one of the most popular options is to convert it to a RRIF.

When you convert to a RRIF, not much changes. You can continue to hold all the same investments and manage the money exactly as you did before. The main difference is that while an RRSP allowed you to put a certain amount in every year, with a RRIF you are required to take out a minimum amount each year. The minimum is based on your age and on the value of the RRIF. Every year on December 31, the company who holds your RRIF will look at its value and based on your age, there is that fixed minimum percentage that you will be required to withdraw. In the first year after you turn 71 the minimum withdrawal will be 5.28% of the previous year’s closing total. The minimum percentage increases each year after that. Of course, you can take out more than the minimum each year but just remember it is considered taxable income.

Tax-Free Savings Account (TFSA)

TFSAs were created by the government in 2009 and allow eligible individuals over age 18, to invest up to a certain amount per year. The contribution limit in 2019 is $6,000. Like an RRSP, if you don’t maximize your contribution in any given year, it is carried forward. So, if you were over 18 in 2009 and you’ve never put money in, your total cumulative contribution room right now is $63,500. Unlike an RRSP, you don’t get a tax refund when you put the money in, however, you can take money out of a TFSA at any time and never pay any tax on the returns or on the withdrawal.

So what should you invest in, an RRSP or TFSA? Well it depends on a number of factors but in most cases, if you are a low income earner such as a young person starting out at an entry-level salary, you should consider using up your TFSA room before contributing to an RRSP. Why? While both accounts grow tax-sheltered, one of the main benefits of the RRSP is a tax refund. If you are in a lower marginal tax rate you won’t get that benefit and since you will never be taxed on TFSA withdrawals, you’re better off growing your money within a TFSA. Let the RRSP contribution room build up and eventually, when you are in a higher tax-bracket, you can contribute to an RRSP.

However, there is an exception that I want to touch on and that is group RRSPs. If you work for a company that offers one, you should consider enrolling in it as soon as possible because you might be missing out on free money. A group RRSP is a great perk designed to encourage you to save at work by contributing through payroll deductions. Depending on the rules of the plan, when you put money in, your employer may match it in some way. It could be that they match your contribution dollar for dollar or that they contribute 50 cents for every dollar you put in etc. There will also be a maximum and it’s typically based on your income.

Let me just quickly put some numbers to it. Say your company has a dollar for dollar plan up to 5% of your earnings to a maximum of $100,000. That means that if you put in $5,000, they’ll put in $5,000 to your RRSP. Their contribution is a taxable benefit to you, but you’ll get a tax deduction for the full $10,000. That’s right. All contributions (both yours and your employers) are tax-deductible to you – and all investment earnings are tax-sheltered. And, if you leave the job, the group RRSP money isn’t locked in. It’s yours and when you leave, you can transfer is to your own individual RRSP wherever you happen to hold it.

Registered Education Savings Plan

This is an account that was created to help parents, grandparents or guardians save for a child’s post-secondary education. And if you have children, it’s a great investment vehicle to consider because it is one of very few places where you can get free money from the government. When you contribute money to an RESP the government matches it with a 20% cash grant, up to a maximum of $500 in grants per year. So that means you can put in up to $2,500/year to get the max $500 grant. Right off the bat, your $2,500 becomes $3,000 - an instant 20% return on your savings. There’s a lifetime maximum of $7,200 in grants that you can receive and a maximum of $50,000 in contributions that you can make.

Like other registered accounts, all of the money in an RESP grows tax-sheltered. However, what’s unique to an RESP is that when it is withdrawn to use for a child’s post-secondary expenses, it will be considered income for the child, not for the person who contributed it. Assuming they are a student and not making a lot of money, the taxes will be quite low or perhaps none at all.

And there you have it. Those are the main types of registered accounts. If you want more information around each, be sure to listen to my podcast on the topic. I go into a lot more detail. And of course, before you take any action, be sure to speak to your financial advisor to make sure what you’re thinking of doing is right for you.