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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2

You’ve Started Saving Money, Now What?

January 25, 2016 - 0 comments

Continuing with my guide for young professionals, the next step is to determine where to put your money. You’ve figured out your budget (or not), and are starting to accumulate savings. Often many young professionals start accumulating cash in their bank accounts, but don’t know what to do with it, especially as it gets larger. There are many reasons to use accounts other than a simple chequing account or savings account, mainly tax advantages and the ability to invest in higher growth securities. If you aren’t sure what the properties of RRSP’s or TFSA’s are, read about them in my post Basic Financial Terminology Explained.

A recent study found that a third of millennials are not at all knowledgeable about RRSP Savings. Many incorrectly believed that you can use RRSP savings to make a charitable donation or pay childcare expenses. Half of respondents also incorrectly believed money in an RRSP could be used to finance a car.

Based on these findings, it is easy to conclude that millennials are unsure where they should be putting their savings. Should cash be moved to a savings account, should you open a TFSA, an RRSP, or an investment account? As always, the answer to that question is: it depends. It depends on what your goals are and what you plan on doing with that money.

Emergency Savings

I believe everyone should have some sort of emergency fund, whether that’s cash saved up in an interest earning account, or at least access to a line of credit. If your accumulated savings is being used for an emergency fund, then your best options are a high interest savings account or TFSA. High interest savings accounts allow you to earn some interest on your savings, and are also often very flexible when it comes to depositing and withdrawing money. You don’t need any forms, and a withdrawal is often as simple as the click of a button or a visit to a bank. Make sure that you check the account details though, since some accounts have restrictions on how many times you withdraw in a month and may charge fees on additional withdrawals.

Another option for emergency savings is to hold it within a TFSA. TFSA's are relatively flexible when it comes to withdrawals as well, especially if the money is in a TFSA simply earning interest at a financial institution or held in a money market fund (interest earning mutual fund) within a brokerage. The thing to remember with the TFSA is that you have a maximum contribution limit. For someone born in 1991 or earlier (and you have been a Canadian resident every year since you turned 18), you will have $46,500 in available contribution room. This has caused confusion for many when it comes to making multiple contributions and withdrawals, so be sure to watch out. (Note: if you are interested in calculating your own TFSA room, contact me at sdaley@pwlcapital.com for a free calculator).

Unfortunately, high interest savings accounts aren’t really high interest savings accounts, with many banks offering less than 1%. For this reason, I think investors should hold their emergency funds within a TFSA if they have not been able to max out their TFSA and RRSP for long-term investments, otherwise use a simple interest account. The tax you save on the high interest savings will most likely not outweigh tax on long-term investments held in a non-registered account in the current environment.

Going Back to School

If you plan on going back to school, you have three account options for savings: a savings account, a TFSA, or an RRSP (You may also want to check if you are the beneficiary of an RESP that has funds in it). Canada has a program called the Lifelong Learning Plan (LLP), which allows you to use funds within your RRSP for education. You can read more about the program here. A summary of the plan is as follows:

  • You can withdraw money from your RRSP to pay for you or your spouse/common-law partner to pursue additional education on a full-time basis at a designated educational institution.
  • You can withdraw $10,000 per school year, up to a maximum limit of $20,000.
  • You can participate multiple times, but only after you have paid back the full LLP balance.
  • If you withdraw more than the $10,000 yearly limit or the $20,000 maximum, the excess will be included in your income and you will owe taxes on it.
  • Contributions need to be within the RRSP for 90 days before you can withdraw them.
  • You have 10 years to repay the total amount withdrawn and if you do not repay the required amount, it will be included in your income.

As you can see, the Lifelong Learning Plan can be beneficial if you go back to school after working and contributing to your RRSP. As with the Home Buyers Plan (which I will discuss in the next section), the Lifelong Learning Plan is a non-interest bearing loan to yourself. The TFSA or a regular savings account can be more flexible and easier to use, but you don’t get the benefit of reducing your taxes while working, which allows for greater contributions by using the LLP in the RRSP.

Saving for a Down Payment on a House

If your goal is to save money to pay for a down payment on a house, you have three account options: a savings account, a TFSA, or an RRSP. A savings account is extremely simple to use. You earn a percentage of interest but the interest you earn on your account is fully taxable on your income. You can move the money into a TFSA, where you can invest in anything you want including high interest securities where you won’t pay any tax on the growth. Your investments will depend on what your goals are and your time horizon, something I will discuss in the future. Finally, you can invest the money in an RRSP, where any contributions are tax deductible (allowing you to contribute more than a TFSA or savings account) and use the Home Buyers Plan (HBP) to borrow money from your RRSP to put a down payment on your first home. As with the Lifelong Learning Plan, there are a number of rules associated with this plan:

  • You must be a first-time home buyer.
  • You are able to withdraw a maximum of $25,000 total.
  • You must pay back the loan in 15 years (paying 1/15 of the withdrawn amount each year).
  • If you withdraw more than the $25,000 limit or do not pay back the loan each year, the excess or amount not paid is added to your income and taxed.
  • Contributions need to be within the RRSP for 90 days before they can be withdrawn.
  • In order to withdraw the money, you need to prove that you have entered into an agreement to purchase or build a qualifying home.

Buying a house can be expensive, with many expenses popping up on top of the down-payment. For this reason, I would suggest also holding some cash in a TFSA or savings accounts to pay for expenses like a home inspections so you can get at the money without needing to jump through all the hoops to get at your RRSP money.

Saving for a Wedding, Car, Vacation, etc.

If your goal is to save money to pay for any of the above shorter-term expenses, you have two account options: a savings account, or a TFSA. In this case, you should not use an RRSP for savings. You are technically able to withdraw money from an RRSP at any time for any purpose, however you are forced to pay taxes at your marginal rate for that withdrawal. When withdrawing from an RRSP for items that do not qualify for the Home Buyers Plan or Life Long Learning Plan, you also have a withholding tax. This means that if you had $16,000 in your RRSP and wanted to use it to purchase a car, you would only receive $11,200, as the other $4,800 (or 30%) would automatically go to the government. If you are only paying 24.15% in taxes, you would get a bit of that $4,800 prepaid tax back, but you wouldn’t be able to withdraw the full $16,000 you might have thought. More information on the withholding tax charged on RRSP withdrawals is available here. Unlike a TFSA, where you can re-contribute your withdrawals in the following year, with the RRSP, if you withdraw the money without using the HBP or LLP, you do not get that tax sheltered room back. What do I mean by that? As I’m sure you know, you earn RRSP room as you work and earn income. If you make a contribution and then subsequently withdraw the money, you are not able to recontribute the withdrawal, so your total tax sheltered room decreases. Because savings accounts and TFSA’s are more flexible in being able to withdraw funds easily, you aren’t taxed on withdrawals, and you don’t lose available contribution room, these accounts are best for short-term purchases.

Retirement Savings

Since young professionals have a long time until retirement, as much as their savings as possible should be tax-sheltered in an RRSP or a TFSA, so they can benefit from tax-free compounding. For high income earners, an RRSP is financially the better way to go if you expect to have lower income in retirement. This is often the case in retirement as a result of needing less taxable income for mortgage payments and retirement savings, and the tax system favours retirees with additional tax credits and the ability to split 50% of pension income – income from work pensions and RRIF withdrawals. For those that are still starting out and not earning very high incomes and they expect to earn a higher income in retirement than they are now, the TFSA is the better bet. You can read more about the math of why this is the case in Graham Westmacott’s paper RRSP, TFSA or pay down debt?. The TFSA is also better for lower income earners because withdrawals are tax free. This means that many benefits received in retirement that are income tested (meaning that the government won’t give you benefits if you earn more than a certain amount, or they will claw them back after reaching a specified income limit) like Old Age Security (OAS), can still be received because TFSA withdrawals won’t be included in your income.

Summary

The following is a summary of which accounts you can use for each of the above goals.

This post focuses on each goal separately, assuming that you are focusing on one goal at a time. As you can see there is overlap within the above table. So what happens if you are saving for both retirement and a down-payment on a house, for example? In the above table it shows that, you could use both the RRSP and TFSA for both goals, so which one should you use for which? This is something I will discuss in my next blog post.

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