Establish Your Accounts

There are a wide range of choices available to investors when it comes time to open an account and begin putting the investment plan into action. The three main categories are taxable investment accounts, tax-deferred investment accounts and tax-free investment accounts.

When you open an account with an IIROC firm, you can add new investments, transfer investments from other financial institutions and consolidate your holdings without going through the process of opening new accounts. It is simple and efficient. 

  • One major advantage is the convenience of holding your investments in one place.
  • Another is that your financial advisor can clearly see the big picture and provide you with guidance that would otherwise be difficult should your investments be scattered among various financial institutions.

Don’t underestimate the value of these benefits.

Taxable Investment Accounts

The main feature of these accounts is that dividends and interest are taxed on an ongoing basis. Capital gains are taxed when a profit is realized on the sale of an investment.

Taxable investment accounts are the least efficient of all accounts simply because of the tax treatment they receive. As such, they should be considered as a vehicle for long term savings only after tax-deferred and tax-free accounts have been maximized.

There can be three types of growth within a taxable investment account, including interest, dividends and capital gains. Each of these is taxed at a different rate with interest being subject to the highest tax rate. In other words, a 4% return on a GIC may not be as good as a 4% return on a mutual fund, stock or ETF when taxes are taken into consideration.

Since after-tax growth is the only growth an investor gets to keep, taxation is an important factor in making investment decisions in a taxable account.

If you are not comfortable choosing investments that will maximize your after-tax return, you may want to seek input from your financial advisor.

A taxable investment account that is part of a long term retirement plan should be considered as part of a total investment package along with an RRSP account and a TFSA account. By considering all three accounts, a financial advisor can help you allocate investments among these three accounts to create the most tax efficient growth.

Over time, these small advantages can add up and make a difference.

Even if you have a long term focus, you may believe that you have found a short term trading opportunity or a “can’t miss” stock pick. It can be equated to impulse buying when a shopper sees something in a store that they ‘have to have’ because it is on sale and too good to pass up. In most cases, these investments don’t fit within the guidelines of the long term plan that has been established but the opportunity is still appealing.

There is a solution to this dilemma.

You can choose to open a separate trading account that is designated for these types of investments. It would be deemed to be a high risk account and should be limited to investment capital not required for your long term retirement plan. In other words, it should be money that you can afford to lose without having it affect your retirement plans.

It is a topic you should think about and discuss with your advisor.

Tax Deferred Accounts

In Canada the term RRSP has become synonymous with saving for retirement.

Nevertheless, misconceptions still exist and, despite powerful tax incentives, the average Canadian still does not take full advantage of Registered Retirement Savings Plans.

The tax incentives are twofold. The first incentive is the tax credit an investor receives when the contribution is made. The second incentive is that the investments can grow inside the account without being taxed.

At some point in the future the money has to be withdrawn from an RRSP account and it is taxed at that time. In other words, the tax is deferred until the money is withdrawn, rather than on a year-by-year basis.

The misconception about an RRSP is that it is an investment; it is not.

An RRSP is simply an account that can hold a wide variety of investments where the growth on those investments is not taxed.

Banks will often offer an RRSP that can hold only one investment that is typically a term deposit that pays a specific rate of interest. That has led to some confusion that RRSPs are an investment. An RRSP, however, is an account rather than investment and, depending upon the financial institution that you deal with, the investments that can be held in that account are virtually unlimited.

Canadians can contribute up to 18% of earned income each year to an RRSP account and unused contributions can be carried forward. There is a maximum contribution limit which was $22,450 in 2011 but you would have to earn over $125,000 per year to reach that maximum.

With the average contribution in 2009 at about $2700, it is clear that the average Canadian has not been taking full advantage of their RRSP contribution limits.

There is a caveat to RRSP contribution limits. Investors who are members of an employee sponsored pension plan will have their contribution limits reduced.

In the past, investors had to wait for their T4 slips in order to calculate their RRSP contribution room and because these were usually issued in late January, it resulted in a short time frame for investors to calculate their contribution room and make the deposit to their RRSP accounts.

Contribution room is now calculated on the PREVIOUS year’s income and it is now included on the taxpayer’s notice of assessment, which usually arrives in May or June.

If you have the funds available, there is no reason to wait until February to make your contribution when you have been given the exact amount of your contribution room six months or eight months before the March 1st deadline for contributions.

The RRSP is an account designed to help you accumulate savings for retirement. Upon retirement, the account can be converted to a Registered Retirement Income Fund (RRIF) account from which you can withdraw these accumulated savings on a regular basis.

In many cases, the investments don’t need to be changed when an RRSP is converted to a RRIF.

There are a couple of key points to remember about RRSPs and RRIFs. An RRSP must be collapsed during the year in which you turn 71 and at that time you have three primary choices: 

  • The entire amount can be withdrawn and the tax paid on that amount.
  • The investments in the RRSP can be sold and the proceeds used to purchase an annuity.
  • Or the account can be converted to a RRIF and the amounts can be withdrawn on a regular basis throughout retirement, subject to a minimum amount each year.

Of course, you don’t have to wait until age 71 as these same choices are available to you prior to that time.

After age 65, the first $2000 of pension income and/or RRIF income each year is more or less tax free. When you combine the benefits of the tax credit upon contribution, the tax-free growth and the fact that the first $2000 of income each year is tax-free, the case for RRSPs is compelling.

Tax-Free Accounts

If there was any doubt the Federal Government wanted Canadians to take more personal responsibility for their retirement savings, then the introduction of the Tax-Free Savings Account or the TFSA should erase that doubt. It is important to know that a TFSA is an account that can hold a variety of investments, rather than an investment itself.

The investment options are typically the same as for an RRSP.

As with any new product or service, investors are still feeling their way around TFSAs and how they should be used. Make no mistake; these are a great vehicle for those who want to save for retirement.

Over time they could make taxable savings accounts almost irrelevant for a lot of Canadians.

While there is no tax benefit in making the contribution, the growth in the account is tax-free. Unlike RRSP accounts or RRIF accounts, there is no tax paid when funds are withdrawn from the account. It gets better.

Funds can be withdrawn from the account and then be re-contributed in the next calendar year. This is in complete contrast to an RRSP where once funds are withdrawn they cannot be replaced unless the investor has sufficient contribution room.

Another benefit of the TFSA that differentiates it from RRSP accounts is that contributions can continue to be made after age 71. Every year another $5500 can be moved from a taxable account to a TFSA account which can mean more tax-free income for a retiree.

As with an RRSP, there is the misconception that a TFSA is an investment.

These are not investments; they are accounts which can hold any number of investments. No one can ‘buy’ a TFSA or an RRSP. They can make a contribution to that account and then an investment can be chosen.

Amazingly, TFSA accounts have been opened and the deposits left in daily interest savings that pay less than 0.5% per year. The whole idea of a tax-free savings account is to protect your growth from taxes. If there is no growth, there is no need for a tax-free savings account and 0.5% comes pretty close to no growth.

Investors need to seriously explore all options available to them for their TFSA accounts.

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