Do you feel confused about the account options you have now? You now have the options to put your money in a RRSP, TFSA or non-registered accounts. How do you decide which account to use?
Understanding The Investment Account Types
Let’s look at the different accounts and their benefits:
- RRSP is a tax-deferred account with tax-free growth. You invest pre-taxed money and your investment grows tax-free.
- TFSA is a tax-free growth account. You invest after-taxed money and your investment grows tax-free.
- RESP is a tax-free growth account with government contributions. It’s intended to be used by your children to fund their education. There are a number of rules that I will not go into details for this post.
- Full DRiP accounts are regular taxable accounts
- Investment accounts are also regular taxable accounts
These accounts are the usual suspects for an investor. Some of these accounts have contribution limits on a yearly basis:
- RRSP limit is 18% of your previous year’s income up to a maximum of $21,000 for 2009. The maximum is $22,000 for 2010. The contributions carryover from the previous year to the following. You can carry a significant contribution room if it is under-utilized.
- TFSA has a limit of $5,000 per year per individual and it also carries over.
- RESP has a lifetime limit of $50,000 per child.
The Tax Treatment of Different Investments
We also have different income tax treatment on your investments that need to be considered.
- Interest: taxed at your marginal tax rate.
- Capital Gains: 50% of your capital gains is taxed at your marginal tax rate.
- Dividends: not a simple calculation due to the federal and provincial tax credit but can approximate 25%-30%.
What Withdrawing From An Account Mean?
Understanding the impact of where you invest is important. I have described the benefits of different accounts above but you also need to understand what happens when you take some money out.
- TFSA: Withdrawing from this account means you get to put that same amount back later on. You get a credit for the contribution room.
- RRSP: Withdrawing triggers a income of the amount withdrawn at your marginal tax rate.
- RESP: The rules are fairly complex but if it’s used to pay for an education, you are in the clear. Otherwise, you will need to plan. Having RRSP contribution room may save you some taxes later on if your children do not go to school.
Evaluate Your Contribution Cost
I also evaluate the cost of contribution. A discount broker has a fee per transaction whereas a transfer agent doesn’t have any to DRiP. Depending on how much you can invest, this can be a significant factor in growing your investment holdings.
Which Investment Account Do I Use?
Knowing all these facts, when I look at making an investment, I tend to carefully think of what I intend to do with the investment over time. I follow a good number of companies but I don’t necessarily have an investment in all of them. When I have funds available, I follow these decision steps:
- What impact does it have if I put it against my LOC or mortgage? I pull out the mortgage calculator (figuratively speaking as it could well be a spreadsheet) and identify the savings and where it puts me strategically. My mortgage is split in 2 with different terms and rates (one of them variable at the moment).
- Topping up my TFSA account is the next step. Although I do regular RRSP contribution through the group plan at the office for the matching contribution. I will selectively pick a company that has risen to the top of my list while keeping in mind that many of the companies I track do not offer the SPP and OCP with a transfer agent. I also want to leverage DRiPing in my discount broker and as such I make sure that the amount I can invest will provide me with at least a share. In case it fails to meet that criteria, I will give preference to an investment that pays a monthly dividend. The yield of an investment also has an influence. As the years go by and the amount in my TFSA account increase, the yearly $5,000 may not be an issue.
- Look at a RRSP contribution. This type of contribution is strategic for me at this point. I put enough money through the group plan as it is. I also don’t intend to retire from my RRSP account. It’s just another investment medium for me. (There is plenty here for another post.)
- Evaluate my Full DRiP investment. Since I just started, there is plenty of opportunities here. This is really for the long term so capital gains would only be triggered years from now if ever … Consequently, I would have to pay taxes on the dividends earned.
- Invest in a regular account. If you plan on holding for the long term, you may only pay tax on dividends in the short term and pay capital gains much later.
In the end, I do a little bit of everything at once. Some allow for small amounts and others don’t. Having a long-term strategy with a plan to get there will usually answer your dilemma. Just like buying the highest yield investment is not always the best choice, picking a type of account based on the tax savings may not be the best choice either.
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