What is a TFSA and RRSP?

They say there are only two things guaranteed in this life; Death & Taxes.  The older I get the more truth I see in that little pessimistic jingle. I’ve always been one to question the standard.  Because what if there’s a better or more efficient way of going about things.

You can’t avoid death, you can ward it off a bit longer and make the journey towards it more enjoyable by eating healthy, practicing discipline and making positive life decisions.

As for taxes, you may not be able to completely avoid or ward them off either, but you can certainly make strategic moves to reduce the amount you pay.  

I understand taxes are necessary for countries to run efficiently, but the top tax bracket in canada is over 50% of your pay.  You work over half the year to pay taxes to the government. If you enjoy paying taxes, my hats off to you. Personally, I think I can spend my money better than anyone else and wish to see myself and everyone I know pay as little in taxes as possible.

In Canada we have two investment vehicles that allow us to minimize the taxes we pay.  The Tax Free Savings Account (TFSA) introduce in 2008 by the Harper conservative government – and we all thought he was an asshole!  And the Registered Retirement Savings Plan (RRSP) introduced in 1957 by Liberal Prime Minister Louis St. Laurent.  Still no reason to elect an NDP government.

Let’s discuss each a little.

What are RRSP and TFSA?

I’ve heard a lot of confusion over the years regarding these investment vehicles.  Both RRSP and TFSA are accounts that you open to shield yourself from taxes. You hold bonds and equities like stocks, ETFS, and mutual funds inside of the RRSP and TFSA.  For god sake please sell your mutual funds and get into ETFs if you still have mutual funds.

Any growth whether it’s dividends, capital gains or interest via bonds is tax free in both of these accounts.  Withdrawing from a TFSA is always free, whereas RRSP is taxed, we will talk more about this momentarily.

They both allow your investments to grow and reduce the taxes you pay on them.  But they each work a little differently on how they allow you to minimize taxes due.  

RRSP are considered pre tax contribution.  So the money you put into them can actually reduce the annual tax you pay by dropping you into a lower tax bracket.  

TFSA is considered post tax.  So the money you put into this investment vehicle has already been taxed and does not reduce your income tax.  But it has amazing other features

How much money can I contribute to RRSP and TFSA?

There are TFSA contribution limits and RRSP contribution limits, but even if you don’t fill them up this year, each year your total limit is carried forward, so you can contribute in the future.  

As of 2018 the total contribution limit for TFSA is $57,500.  For RRSP, each year after you turn 18 years of age you can contribute 18% of your working salary.  This will obviously vary between individuals.

How to use the TFSA to gain financial freedom

TFSA is the very first account you want to open and begin plugging away to fill up.  Money in here can grow tax free and you can withdraw it at anytime tax free. This is an amazing investment vehicle that everyone needs to take advantage of immediately.  Even if your investment grows 10,00% and you made millions in here, all the money withdrawn would be free of the pervasive sticky hands of the taxman.

Currently you can only contribute $5,500 per year.  When you withdraw, again, you are not taxed but any withdraws you’ve made in one year will be added to contribution room the following year.

For example, lets say you take out $10,000 in 2018. In 2019 you will be able to contribute $15,500!

For someone who currently has their TFSA maxed out, if they continued maxing out their $5,500 yearly contribution, in 30 years this alone leaves you about $7,000 shy of a million based on an average 7% return – completely realistic and possible!

If you haven’t realize yet, this is huge.  Go open a TFSA account with Questrade!

How to use the RRSP to maintain financial independence

You don’t need to wait until you are financially free to be utilizing an RRSP, far from it.  But TFSA is the first vehicle you should be filling. RRSP has a few different uses than the TFSA.  As you should remember from above, the RRSP is a pre tax contribution investment vehicle. So you can use contributions to reduce the tax bracket you are in.  This can work wonders for someone making over $46,000.

For anyone making lower than that, it’s best to focus on filling the TFSA and leave contribution room for when you are making more money to drop down a tax bracket in those high earning years.

Another thing to note about RRSP is that when you do withdraw money, it is taxed.  So the idea is to stash money away to reduce your income tax bill in working years, then withdraw money when you aren’t making much money at a lower tax rate – retirement for example.

Unlike the TFSA, when you withdraw money from your RRSP the contribution room is lost and you do not get to add it back the next year.

There is a deadline each year to contribute to a RRSP to reduce your income taxes, this year it was March 1st. 2018.  You also cannot contribute to an RRSP after 71 years of age.

Which type of investments to hold in RRSP and TFSA?

Hopefully at some point you amass so much money that you have maxed out both accounts and cannot shield any more money from taxes.  It’s a great problem to have.

At this point you want to be strategic about which types of investments you hold in each account.  Different investments grow and make money differently, thereby are taxed differently.

Dividends from equity stocks and ETFs are taxed the least.  So if you hold some bluechip dividend producing equities that don’t grow a lot, you would want to hold outside the tax shielding vehicles TFSA and RRSP if you need to.  

Capital gains are taxed less than your marginal income tax rate.  Capital gains happen when you sell at a higher price than you bought at.  So if you buy an ETF for $22 and sell for $25 you have a capital gains of $3.  Investments that produce capital gains are next what you want to hold outside TFSA and RRSP if you need to.

Interest from bonds are taxed at your normal rate.  If you need to hold bonds, which in later years when you are closer to financial freedom or retirement you will want to for the lack of volatility that they come with, you will want to keep these in an RRSP always.  

Don’t put bonds in TFSA because TFSA is for investments that will grow lots.

Live tax free in retirement or financial freedom using RRSP and TFSA

Congratulations you are financially free or retired and are ready to start withdrawing your cash.  Since Canadians are tax exempt up to around $11,000. You could withdraw that amount from your RRSP, use $5,500 to fill your TFSA and then take the other $5,500 for living expenses.  You can always withdraw money from your TFSA, you can also use that for living expenses.

In the next year you will be able to put $11,000 into your TFSA and every year you can withdraw $11,000 from your RRSP tax free, to be put into the TFSA to later be cycled out again for tax free money.

This little strategy allows you to remove money slowly from your RRSP to avoid paying taxes.  This is also why you will always want to keep your TFSA pumped up.

Conclusion on how to use a TFSA and RRSP

These are both tax advantageous investment vehicles that allow you to keep more of your wealth.  Everyone should be utilizing them. If you still don’t understand how to use them, reach out to a tax professional or fee only financial advisor.

I promise you they are easily to use, go to Questrade to open a TFSA or RRSP today!

Dear readers, are you using the TFSA and RRSPs?  Is there any clever tricks I have missed to utilize them even further?  Let me know in the comments!

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