I think it’s time to have a look at the best tools for adding leverage to financial independence : the registered savings account! There are a few registered accounts that the government of Canada let us use. The RESP (Registered Education Savings Plan), the RRSP (Registered Retirement Savings Plan) and the TFSA (Tax Free Savings Account). For financial independence, I will only show you the benefits I found in the RRSP and the TFSA, but if you have kids, you might want to have a look at the RESP.
Remember that you need to assess your own situation and risk before taking action. Also, make sure you closely follow the rules of these accounts. If you want to know how much contribution room you have left, register and login on the Canada Revenue Agency Website.
I suggest you go on every link I provided above to make sure we start on the same base even if I’ll repeat some of the concepts in the post. We’ll go one account at a time and conclude with my own strategy.
RRSP (Registered Retirement Savings Plan)
How You Can Open One?
At your financial institution or on an investment platform like RBC Direct Investing or Desjardins Disnat. You can have as many RRSP as you want in as many institutions as you want, as long as you don’t go over the contribution limit and you follow the rules. Also, you can put your funds in Mutual funds, ETFs, stocks, bonds and the like.
The Good and the Not So Good
The important part is that income tax is deferred until you withdraw the money later on when you retire, the interest you’ve made on that money while in your RRSP account won’t appear on your yearly tax report but you will pay tax on it at withdrawal. The point is to take out the money when your income is less than what it was during your career, in hope of paying less income tax on the money. It’s a double edged sword because you have to make less income if you want to pay less tax after retirement which is not always the case. Also, if you die, then your beneficiary might have to pay a large amount of taxes on the RRSP. Finally, some people won’t make so much less because of other income sources and will find themselves paying as much taxes as when they were in the workforce.
The thing is, people often make more money when older and the RRSP acts like a savings account if you don’t have enough time before you start withdrawing which is a bit counter productive in my opinion. It’s a risky account because we don’t know what the future holds. Yet, it can help many of us save for retirement by building our own nest egg without relying on the CCP/RRQ to do it for us.
On your regular investment account, you pay income tax on dividends and capital gains but you can also claim capital loss. That’s kind of an advantage in case you need to withdraw during market downturn or if you want to switch an investment for another.
How it works:
In: When you put money in, the registered account will reduce your taxable salary by the amount transfered. Let’s say my pre-tax salary is 50 000 $ and I put 10 000 $. My taxable income will now be 40 000 $ therefore I will pay less tax right now.
Out: When you want to take money out, it will be added on your current salary for the year.
For FI People
This account can be useful because it will make sure you can save as much as possible right now and, because you plan your finances in advance and will stop working or start working on personal projects, your revenue will go down drastically. That will let you control the amount of money you will make during your years of FI, therefore, you can almost garantee to stay in a lower bracket at the moment of withdrawal because you won’t have a pension or CPP (and/or RRQ) coming in boosting your salary. Your amount of expenses may help you stay in the lower income also which is a strong point for this account. Someone who only needs 20 000 $ to live will benefit.
Bottom Line For the RRSP
When pursuing financial independence, the goal is to boost your investable income right now and control what comes out when leaving the workforce at an early age. The RRSP hasn’t been planned for early retirement and can be used to help achieve it.
Note: you will be held a special tax when taking out money from your RRSP, make sure you plan accordingly.
Tax Free Savings Account (TFSA)
My favourite one! This account is the holy grail for anyone. You put already taxed money in there and it generates tax free cash for you! You must follow the contribution limits but other than that : tax free!
How You Can Open One?
Pretty much like the RRSP, i.e., at your financial institution or on an investment platform like RBC Direct Investing or Desjardins Disnat. You can have as many TFSA as you want in as many institutions as you want, as long as you don’t go over the contribution limit and you follow the rules. Also, you can put your funds in Mutual funds, ETFs, stocks, bonds and the like.
The Good and the Not So Good
Whatever happens in the TFSA stays in the TFSA. For example, if you put 10 000 $ in your TFSA and invest everything in a small company that grows 10 times its current value, you now have 100 000 $ producing tax free gains for you. I absolutely don’t suggest you do that by the way! It’s just to illustrate that the gains (and losses) on your investments are tax free and do not affect your bottom line at the end of the year. You can take out any amount you want at any time and will be able to put some or all of it the next year depending on your contribution limit. That’s why I’m saying it’s a tax free money generating machine.
It’s also a double edged sword if your investments go down a lot, you won’t have more contribution room. Example: you have 6 000 $ in contribution room and you invest 6 000 $, it’s now in the market but it loses value to 4 000 $. You will not have an extra 2 000 $ contribution because of that. As I say, one must invest long term to really reap the benefits of the TFSA.
In any case, if you invest long term, it’s very likely that at some point, you will have a lot more than the max amount you can contribute to generate income for you. Another example: let’s say you’ve been invested for quite some time and you’ve maxed out your TFSA at 57 500 $ (money that went in) as of 2018. But all the gains and the years have made this amount into 120 000 $. You would now be making dividends and gains on 120 000 $ which is a lot more than the maximum amount you could contribute. That’s the real power of this account, and the best part is, I know I said it already, that everything you take out from it is tax free.
To continue on the same example and to give you an idea of what it means, if for this year the maket went up 7 % (with dividends and after fees), your 120 000 $ would now be 128 500 $, a whooping 8 500 $ in tax free money. In a standard investment account you would have to pay taxes on the gains and the dividends depending on how the money is invested, but you could also claim a loss which you cannot do in a TFSA as it’s off the tax map.
My opinion? This account should be maxed out as soon as possible to benefit from all the possible gains in the future and to get ahead of the limit as soon as possible and really reap the rewards of the TFSA. Only the big amounts make a real difference because it surpasses the cost of living, take 7 % interest of a million dollars and you got the salary of a medium – high income earner added on your investments (70 000 $).
For FI People
It’s really good for financial independence aspiring people as most of us invest in Index ETFs. That makes the odds of getting ahead pretty good. Chances are that you will be making a whole lot of tax free money that you can play with later with a very high saving rate. In my opinion, you should fill out this account before opening a standard investment account.
Bottom Line For the TFSA
The TFSA is the best account for the long run as the more you wait to withdraw money from it, the more tax free gains it generates for you. In my honest opinion, everyone, not just FI aspiring people should max out this registered account.
Note: make sure you check out on your maximum allowed contribution for the year and you keep track of it. You can find all this information on your Canada Revenue Agency account.
My Financial Independence Strategy
This strategy might give you some ideas for your own. If all the rules in place stay the same as of this year (2019), I will be feeding the following account in order.
- RRSP (when salary is higher than 47 000 $), supplied in the beginning two months on the year.
- Regular investments (all the rest goes there).
To sum this up, here is the order in which I will take money out after I’m done “working for someone else”.
- RRSP and regular investments in parallel.
- Regular investments.
- Regular investments and TFSA in parallel.
TFSA is my number one priority because I want the maximum long term return at all time. Since everything that comes out of it is tax free, I want the highest possible amount in there. As soon as the CRA announces the new contribution limit, I put money in on the first months of the year. This will be the last account I will withdraw from. My strategy will be to use it as a side income to reduce the amount of tax paid from my regular investments while having a higher income overall.
RRSP is my number two, and the most secure of them all (still 80 % stocks/20 % bonds given my “shorter” horizon). This is because it will be the first to be tapped into once I quit my daily job. Why? Because I know that my first years in early retirement are less likely to bring money from my business than the next. The result will be less tax at withdrawal than when I had a real salary. The RRSP is good to contribute in but is even better the higher your salary is, that’s why I’ve set a threshold to stay in the lower tax brackets as much as possible. This is to have the least amount of dollars taxed at a higher rate. I don’t really care if this account one is not filled up to my max contribution every year.
Regular Investments can sometimes go over RRSP, because this will be my second source of income when in early retirement. The reason is it should protect my TFSA and make sure it grows for as long as possible. In fact, we cannot escape income tax and shouldn’t, the point is to contribute for the greater good but we can use tax advantaged vehicles, capital gains and dividends to reduce our salary once we’re retired.
I welcome any ideas on the best ways to use the registered accounts to leverage FI as well as some strategies that I could elaborate on.
As a final note, make sure you do your research and establish a plan for yourself, this is my current plan in my situation and is to illustrate how it could be done. If you have any other questions, please consult a financial planner or the links below.