I’ve said it before: I find it SO crazy that kids come out of school knowing the history of Russian Tsars but relatively little about how to manage their money. My dream would be to one day give 'finance basics' presentations at high-schools and teach kids about saving, investing and the stock market so they're better prepared in the 'real' world....but for now I'll just ramble about financial stuff here.
Two key savings tools available to us Canadians right now are the Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plans (RRSP's), and I'm not sure if everyone is using them to the full extent! Let's explain them first:
Acronym #1: THE TFSA
If you get into the details of the TFSA, it can be a little overwhelming, but to describe it simply it’s what they call a ‘tax-sheltered account.’ This means for all the cash you stick into your TFSA, the tax man can’t touch it. "How is this different from a regular savings account" you ask? Good question, as you've already paid tax on the money in your savings account! Well, any interest you make on your savings in a regular savings account will be taxed, whereas the interest you earn in a TFSA would not be. Now, at 1% interest rates in savings accounts these days, that's not really a big deal (you might save a few bucks over the year), but if you invest your TFSA money in stocks or GIC's or mutual funds for example, and make 4% in dividends or sell a stock for 20% more than for what you bought it at, this can mean big savings when you don't pay tax on any of it!
But even if you're not investing your TFSA savings in stocks or anything, it's just a plain ol' good place to stick your money for when you need it later. Some call it a 'rainy-day fund.'
Acronym #2:The RRSP
So now let's talk RRSP's, the other saving tool in the Canadian's arsenal. Here's the big difference between a TFSA and RRSP: with an RRSP (Registered Retirement Savings Plan), the money you put into it hasn’t been taxed yet; the taxes are simply deferred to a later time (i.e. retirement) when your income, and therefore your tax bracket, has theoretically decreased. So ideally you stick money into an RRSP when you’re in a high tax bracket and take it out when you’re retired and in a low tax bracket.
What they did teach you in school most likely is to ‘save for retirement,’ so you can golf and go on luxury cruises to your heart’s content when you’re old and grey. Ideally, it’s best if you can use both your TFSA and RRSP and fill ‘em up every year to guarantee the most tax-saving benefits. But that requires a lot of cash! So if you were to only choose one, which do you go with? Well, there are a few factors to that decision:
1. Are you making significantly more now than you expect to be when you’re old?
An RRSP is only effective if you’re making a way better income now than when you take out the money. For example, if you’re making $60,000/year now, and expect to be making $50,000 when you retire (from RRSP withdrawals, investments, and maybe you’re working part-time somewhere), then there isn’t much point. Similarly, I wouldn’t recommend putting money in an RRSP when you’re working a paper route for $10,000 a year because there’s a good chance you’ll be making more when you retire. It’s also extremely speculative and hard to know: what will you be doing in 30 to 40 years time? With a TFSA, you’ve paid your taxes and now you’re dealing with straight no-worries cash that you can withdraw any time.
2. Are you making a huge salary?
Some experts think that if you’re making less than $75,000 the advantages of an RRSP might not be that significant and you’d be better off with a TFSA.
3. Would you possibly be taking this money out for big purchases like a house or car in the near future?
A TFSA is the best choice as you can take money out of your TFSA without any penalty. If you take money out of your RRSP early you might pay a ‘withholding tax’ penalty- however there are exceptions. For example depending on where you live, you might be able to take money out of your RRSP to put towards a mortgage without a penalty.
Finally, an RRSP might be a better choice if you are an impulse shopper and you want to put money away for retirement, as it is much easier to take out money from your TFSA than it is from an RRSP.
4. Is your company matching your RRSP? In other words, if you deposit $100, do they also throw in $100?
This is a sweet deal! I would make use of this.
5. Will you invest in stocks, safe investments like GIC’s, or just leave it in there as cash to gain interest?
TFSA’s are better for high-interest paying stuff like dividend paying stocks as you don’t pay tax on the dividends you make, whereas you will pay full tax on those dividends when you take that money out of your RRSP.
Well I hope that makes some sense. When it all boils down, at least you’re saving some money and using at least one of these tools.