Friday, July 1, 2022 / by Mario Daniel Sconza
Financial Friday #115: Procrastination with a TFSA & RRSP a Fatal Mistake!
Getting started with a TFSA and RRSP is a lot easier than you think… and putting it off will end up costing you a pile of cash in the long run!
There are volumes of information out there explaining every aspect of Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs). Articles on how to optimize your contributions to each based on your tax bracket and expected future earnings, details of the overcontribution rules and penalties, why the age of 71 is a big deal…. and plenty more.
We like getting the facts, but this information overload isn’t much help if you are simply wondering what these things are and why everyone talks about them so much. The mountain of details is not only confusing, it may also discourage you from investigating more — and that would be a huge mistake!
Everyone should be aware of three things about RRSPs and TFSAs:
- They are free and not difficult to open.
- You can get a TFSA anytime after age 18 and even earlier for an RRSP (basically as soon as you start work).
- The younger you start, the more money you are going to make.
The biggest RRSP/TFSA mistake is procrastination; it has nothing to do with the minutiae of the rules or how to best to invest your money. Don’t put off getting one (or both) until you are older and/or have more money. And don’t think these accounts are just for retirement. You will definitely get older, but the "having more money" part isn’t guaranteed. Keep reading this article to learn the essentials, but make sure you put your newfound knowledge into action.
1. While TFSA and RRSP both have "savings" in their name, they are actually designed for investing your money, not saving cash. After you put money into a TFSA or RRSP, you should be investing it, not just letting the cash sit there. Rising prices will quickly eat away at the value of your cash pile, so you need to invest to fight back against inflation! Fortunately, you have a lot of options for investing your money.
Most Canadians invest the money in their TFSA and RRSP in some type of funds (mutual funds or exchange-traded funds). These funds are basically a basket of different stocks, bonds and other financial instruments — there are thousands of funds available. Some are broad-based and include many companies across multiple industries, while others focus on a particular industry or region. The risk varies greatly from one fund to the next and you will need to factor your risk tolerance into the funds you choose.
Funds are professionally managed and you need to be wary of the built-in management fee (called an MER), but they do make it easy for anyone to get invested. You don’t have to pick individual stocks and you don’t need anyone to help you if you want to do it yourself. Many Canadians handle their own investments and there are number of online options to self-manage the funds you hold in your TFSA or RRSP. There are also "all-in-one funds" with varying degrees of risk that are very convenient for beginning investors. There is even a fully automated online option called a robo-advisor that continuously adjusts the funds you hold to match your financial situation and goals – all you have to do is deposit the money!
While you don’t need a financial advisor to choose investments that are right for you, you are responsible for learning the basics of investing and making sure you understand the risks involved, regardless of whether you do it yourself or seek professional advice.
2. No one should be discouraged from opening a TFSA and/or RRSP because they only have a "little bit" to spare, and it wouldn’t seem to make much difference. The first argument against this belief is that building a savings habit requires the right mindset and is a skill. No one is born with a genetic predisposition to savings. You may be influenced as a child by the savings habits (or lack of) from those around you, but getting into the habit early will get you started down a very long, profitable road due to the wonders of something called ‘compound returns’.
Investing $200/month from age 18 to 65 at 7% would give you $790,139. The same $200 at the same rate from age 28 to 65 would yield just $384,810. Sure, you would be contributing $24,000 more over those extra 10 years, but your nest egg at 65 would be almost double.
A lot of young people get discouraged by the sheer amount you are allowed to contribute — and for good reason! If you make $60,000/year salary, your annual contribution maximums are $6000 to your TFSA and around $10,800 to your RSSP. That’s $16,800; a pretty big chunk of your take home pay! The good news is that your yearly contribution limits can be carried over and as you grow older (and theoretically have more disposable income) you can catch up.
3. There is no need to choose between and RRSP or TFSA. As your financial situation grows and changes you can definitely benefit from both. The main reason is that the timing and impact of the income tax benefits is very different.
In short, you delay paying tax by putting money into your RRSP. When you fill out your income tax return, you get to subtract the money you put into your RRSP from income — and that will result in a very noticeable reduction of your income taxes for that year. The higher your tax rate, the more you will save! However, before you go out and spend these tax savings, make a mental note that you are only delaying or deferring that tax to later in life.
Your RRSP should grow substantially over time if you are invested (see #1). However, any money you take out of your RRSP down the road is fully taxable in the year it is withdrawn. The advantage is that if you are retired, your income and associated tax rate could be substantially lower than when you were working. This will reduce the impact of taxes, but only to some degree! In fact, if you have a lot of income in retirement, withdrawing from your RRSP could create a hefty tax bill.
If you had put the cash into a TFSA and invested it the same way, you would have the same amount of money, but you would be able to take it out and spend it tax free. You would have received no reduction in your taxes when you put the money into your TFSA, but you don’t have to pay tax on that money when you take it out of your TFSA.
An RRSP will put more money in your jeans today than a TFSA because of those immediate tax savings, but the opportunity to invest and grow tax free money for the future in a TFSA is also very alluring. There are lots of other considerations (flexibility of withdrawals & your tax rate for example), but we will leave that debate for another article, just get one, or both, and get started!
4. It is relatively easy to get started. You need to be 18 to open a TFSA (not for an RRSP) and both accounts require a social insurance number. You can open them in-person or online at most banks, credit unions and investment brokers. There are no fees to open one, although some institutions require a minimum balance. Both the TFSA and RRSP are a type of "registered account" and are not used for daily banking. They differ from your savings or chequing account because the cash flowing in and out is tracked to make sure you follow the rules and the tax implications can be managed.
5. You can put funds into your TFSA and RRSP anytime throughout the year, but there are annual limits. For a TFSA, the amount is the same for every Canadian regardless of their income. For 2022, the maximum contribution limit is $6000. For an RRSP, you can put away up to 18% of your income up to a maximum of around $28,000.
If that sounds like way more than you can spare, the good news is that you can carryover unused contributions and catch up later. In fact, if you are over 18 and are just now eyeing your first RRSP or TFSA, you already have unused TFSA contribution room available. You may also have some RRSP room as well depending on your income. You can confirm these amounts on your most recent income tax assessment. Just remember that catching up on contributions will be harder than you think and as we already mentioned, your nest egg will have less time to grow.
Although you can contribute funds anytime during the year, there are some dates you need to be aware of. For an RRSP, you need to get the money deposited (not invested!) by the end of February in order to claim a tax deduction for the preceding year. If you miss the deadline (even by a day) you will have to wait until next year to reduce your taxes. For a TFSA, the official deadline is December 31, but since the contribution limit can be used in any subsequent year and there is no tax deduction, there really is no deadline. There are also penalties for overcontributing to either your TFSA or RRSP, so make sure you understand the rules.
Even if you are not forgetful, it is a great idea to set up your bank account account to automatically transfer a fixed sum every payday into your TFSA and RRSP. You can’t spend what you can’t see, and it will force you to save. You also won’t have to run around like a lunatic every year trying to find the money and make the contribution deadline!
6. The last thing to know is that registered accounts are not just for retirement. You can use your RRSP to save up cash for a down payment on a home and then "borrow" up to $35,000 ($70,000 for a couple) from your RRSP to purchase the home under the Home Buyers’ Plan. You do have to repay the borrowed funds over a period of years, but you do not have to pay tax when you withdraw the funds. TFSAs offer even more flexibility with no tax due on withdrawals and you get to keep your contribution room, although you have to wait one year before you can replace any of the funds you took out.
There is a lot more that can be said about TFSAs and RRSPs but the short story is, if you don’t have one, you are seriously missing out. It’s time to get moving!
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