Saving money is such a critical component of financial success. Unfortunately, Canadians have not been good savers for a long time. Not only has the savings rate been on the decline since it peaked in 1982 at over 20%, but it’s been below 5% since the late 1990s.
Related article: 5 reasons people are not saving money
One of the problems is that saving money is not a natural habit. Very few people come out of the womb with the savings gene.
Related article: Are you a natural saver?
Saving money is a learned behaviour, and few people are given the opportunity to learn it properly. You don’t get much of a financial education in schools, and it’s rare to find programs in the workplace. Most people are left to learn about saving money at home. Unfortunately, most parents are not good savers themselves, and many never talk to their kids about money.
Why save money?
I guess the answer to this question really depends on your goals. Some people save to spend—they are planning to buy a car, or a house, or shoes, to take a vacation, or to renovate the kitchen. Some people save for their children’s education. Others are saving for retirement. And yes, believe it or not, there are some people that are just saving because they can’t spend all their money.
The first step in saving money is to know what you will use the money for, because this will help determine the appropriate savings vehicle. For example, if you are saving money for your child’s education, then a Registered Education Savings Plan (RESP) will likely be the best tool. If you’re saving for a holiday, you would never use an RESP. Instead, a Tax-Free Savings Account (TFSA) would be much more appropriate. Saving for retirement is probably the most complicated, because you could use a Registered Retirement Savings Plan (RRSP), a TFSA or several other options.
The key point for now is that saving money for your future is best done when you have a clear idea of your goals.
Which type of account?
Before we go further, it’s important to understand the difference between an account and an investment. This idea is often misunderstood by people who are starting their savings journey. One way to understand the difference is to think of an account as a bucket, and an investment as something you carry inside the bucket.
The various account “buckets” in Canada include the ones we just mentioned—Registered Retirement Savings Plans (RRSPs), Tax-Free Savings Accounts (TFSA), Registered Education Savings Plan (RESPs)—as well as Registered Retirement Income Funds (RRIF), Locked-in Retirement Accounts (LIRA), and plain old non-registered (taxable) accounts. Each of these has different rules regarding the amount you can contribute, when you can withdraw the money, and how the growth and income are taxed.
An investment is a type of asset that you hold inside one of these buckets. For example, with the money in your RRSP bucket, you can buy a whole range of investments, such as mutual funds, stocks, bonds, Guaranteed Investment Certificates (GICs), exchange-traded funds (ETFs), and many others.
Let’s quickly walk through the four main accounts you can use to save money:
Registered Retirement Savings Plan (RRSP)
The RRSP was created back in 1957 and is primarily used to save for retirement. The incentive to use a RRSP is really tax-driven: When you put money into an RRSP, your contribution qualifies for a tax deduction. Any investment growth is tax-deferred until withdrawal. But when you eventually take money out of your RRSP (usually in retirement), it is fully taxable. You can also make early withdrawals from RRSPs to buy your first home or to pay for your own education. Your RRSP contribution limit is determined by the amount of income you earn.
Related article: Online guide for RRSPs
Registered Education Savings Plan (RESP)
The RESP is designed specifically to help you save for a child’s education. RESPs are attractive because of the Canada Education Savings Grant: for every dollar you contribute to the RESP (to a maximum of $2,500 per child per year), the government will contribute 20 cents. As long as the money stays in the plan, there is no tax on any investment growth. Later, when the money is withdrawn to pay for your child’s education, the growth is taxed in the child’s hands, so there is usually little or no tax.
Related article: RESP Rules
Tax-Free Savings Accounts (TFSA)
The TFSA is the newest type of account, as it was just introduced in 2009. Unlike the RRSP, there is no tax deduction for contributions. However, all investment growth is completely tax-free, and you can withdraw money from a TFSA any time without any tax consequences. The maximum contribution is currently $5,000 per year for anyone over 18. If you withdraw money, you get that contribution room back the next year.
Related article: The rules of the TFSA
A non-registered account is just a general investment account. It offers no tax deduction on contributions, and all of the growth is taxable: interest income, dividends, and capital gains have different tax treatments, but the Canada Revenue Agency takes a slice of each. In most cases, you would only use a non-registered account when your TFSA contribution room is all used up.
As you can see, different accounts have different tax treatments and different rules. That also means different accounts will be more appropriate for different savings objectives. You can save money more effectively if you choose the type of account that is the best match with your savings goal.