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TFSAs and RRSPs Are Not Investments

If you open a TFSA and put some money in there, is it invested?hand writing

Is the money you put into that account guaranteed to grow?

Can you simply pull money out of your RRSP to use it for other purposes, like paying down debt, without any issues? Is that possible?

I’ve just had several conversations with people that made me realize there is a lot of confusion around these structures. Most of the assertions I heard and the questions I fielded had two things in common: First, there appears to be a belief that TFSAs and RRSPs are in and of themselves investments.

They’re not.

Second, there is a perception that they both work in similar ways – you put the money in, it grows tax-free, and and you can withdraw it whenever you want without any issues.

It doesn’t work that way.

What are they, then?

TFSAs and RRSPs are not investments, they’re tax-sheltering structures. You can open a TFSA or an RRSP, but until you put some money in them, or purchase qualified investments within them, you have empty structures that won’t do you any good.

Let’s use a real estate analogy. Think of TFSAs and RRSPs as houses – they provide shelter from the elements, but until someone steps inside, they’re empty structures that don’t do much of anything except cost you money, in the case of accounts that have fees associated with them.

When you buy investments inside a TFSA or an RRSP, the growth is sheltered from tax. In that way, they’re alike. However, they work in different ways regarding the money going in and the money coming out.

Here’s the scoop:

Registered Retirement Savings Plan

This product, created to encourage Canadians to save more for retirement, has been around since 1957. It has evolved substantially since its inception, to the point where today you can invest as much as 18% of your earned income to a maximum of $26,230. What counts as earned income? Check out this Tax Planning Guide for an easy-to-read chart.

If you haven’t done your taxes, then you’re out of luck regarding contributing that year. You need to file your taxes in order for the government to determine how much contribution room you have. The latter is listed on your Notice of Assessment.

The good news

When you make a contribution to an RRSP in the form of a qualified investment, you can deduct that amount from your taxable income. In other words, you get to save on the amount of tax you pay in the year that you make the contribution.

What you need to know

If only it were possible to avoid paying tax altogether! Sadly, this isn’t Utopia, so tax must be paid at some point, and in the case of an RRSP, that happens when you withdraw the money. Since the government will use your tax bracket at the time of withdrawal, the idea is to contribute during your high income years to maximize the deduction, and to withdraw when your income is lower, typically at retirement. While you do pay tax, if you legitimately work the system to your advantage, you can save money on the total amount of tax you pay.

German Sheppard sitting with ears up and eye looking intently forwardI want you to think of RRSPs as a house that has a big guard dog at the Exit door. The money goes in easily, but there is a consequence to withdrawing it in the form of taxes and possibly also fees if you have the funds invested in products where the money is locked in for a fixed period of time, like GICs, or back-end loaded mutual funds, where there are costs when you sell too soon.

Key decision

When you put money into an RRSP, you need to decide what type of investments you want to hold inside the plan. Do you want an index fund or ETF? Would you prefer bonds? GIC’s? A mix?

Click here for a list of permitted investments inside an RRSP.

If you have no idea which investments to select, I can recommend two short, simple books that will help you get going:

  1. The Smartest Investment Book You’ll Ever Readby Daniel Solin
  2. Playing the Winner’s Game: Think, Act, and Invest Like Warren Buffett, by Larry E Swedroe

Here’s something to bear in mind: Whomever you turn to for advice on specific investments, just ensure that they don’t have a vested interest in what you buy. Asking a banker for advice on which of his/her investment products to select is like a chicken asking a fox for feedback on security measures at the chicken coop. Don’t blame the fox for his response – he’s just being a fox.

Banks are out to make money; that’s their mandate. Most people in a given branch have sales quotas to meet. It’s not their job to look after your best interests; that’s your job.

Just to be clear, I’m not knocking people who work at banks. I have an excellent professional relationship with three banks and I rely on the people I interact with for information about their products. They tell me what they have, they explain the various options, and that’s it. I take that information and run it through my “what’s in my highest, best interest” filter before doing anything. I also shop around extensively to ensure that I am getting the very best product or option for me.

Recap

RRSPs are structures in which you invest before-tax dollars. Any growth realized by your investments is tax-free while the investments are held inside the plan. When you withdraw the money, you are taxed at your current tax rate. Bear in mind that there are also fees associated with selling certain investments. How you invest the dollars you put into your RRSP is entirely up to you, but if you just put cash into an RRSP, you won’t get much growth. How much is your savings account paying you, even the high-interest savings account? Piddling amounts, right? If growth is what you’re after, read the two books I mentioned and go from there.

For specifics on how to open an RRSP account, check out this link from the Ontario Securities Commission.

Tax Free Savings Account

This is the darling newcomer on the scene. Created in 2009, it has one huge advantage. OK, it has two: First, you don’t need earned income to invest using a TFSA. Hurray for business owners who don’t have earned income! Second, you can withdraw the money at any time without any tax consequences because you’ve already paid the tax on the money that went into the account.

In other words, there is no guard dog at the exit door of this tax-sheltering structure!

The good news

Once you’ve paid income tax on your earnings, you can use the remaining funds to invest inside a TFSA up to the maximum contribution limit (see below). As with funds inside an RRSP, any growth realized from the investments is tax-free. Forever. How cool is that?! This is a brilliant tool for young people whose earnings aren’t high enough to yield much contribution room, or have much of an impact on tax reduction, using RRSPs.

This account can be used as a savings mechanism for both short and mid-term goals since there’s no penalty for withdrawing funds at any point. Why keep your money in a standard high-interest savings account when you can do the same inside a TFSA? If your comeback is that you’d rather reserve the TFSA for higher growth investments for the full benefit of tax-free growth, fair enough. That means that you have more than $57,500 to invest (see why below). Awesome! I couldn’t agree more. However, if you haven’t maxed out your contribution room, growth of any kind inside a TFSA trumps growth outside of it.

What you need to know

You don’t reduce your taxable income in the year in which you invest. Again, that’s because the funds going into a TFSA are after-tax dollars. But did I mention that the investments can grow tax-free moving forward? Thought so.

One more thing to consider: If your TFSA investments are comprised of stocks, mutual funds, and GICs, and you need to get your hands on the money quickly, there are often transaction fees charged when you sell them. Take the time to understand the costs associated with the investments you select for inclusion in your TFSA in order to minimize fees. It’s worth remembering that fees top the list of factors that affect your ROI. Minimize or avoid them where possible.

The details

Banks, insurance companies, credit unions and trust companies can all issue TFSAs. Click here for a list of approved investments. Consider opening a self-directed TFSA to build your own portfolio of investments. As always, do your homework and shop around for the best, low-cost option.

You can have multiple TFSA accounts, but you can’t exceed the maximum allowable contribution amount. Currently, the 2018 contribution limit is $5,500 and the cumulative total is $57,500 (i.e. the total contribution amount from 2009 to today). If you haven’t invested a dime in TFSAs so far, you can invest up to $57,500, assuming you were 18 or older in 2009.

One final point: Unless you’re investing in a product with a guaranteed rate of return, like a Guaranteed Investment Certificate, there are no guarantees. Investing generally comes with risk. It would be a mistake to assume that if you invest in a mutual fund today, it will be worth more next year. It may or may not. I suggest you read the two books I recommend to learn about mitigating risk. More on the latter coming up on my blog; stay tuned.

Happy tax-sheltered investing!

(Quick note: Links to books in this post are affiliate links, which means I am paid a small commission if you buy using that link. There’s no extra cost to you and it helps to fund my work. I only recommend books I personally own and love.)

If You Enjoyed This Post, You’ll Also Like:

Women & GICs: Are They a Good Fit?
Women and Investing: How We Benefit From a Lack of Confidence
Does Your Advisor Really ‘Deserve’ to be Paid?

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