As a general rule, when you make money, you pay tax. It’s true when you earn income from a job. And it’s also true when you record a gain on an investment. But there are some very useful ways the government allows you to reduce the income tax you’ll pay and avoid paying tax on your investments.
Let’s take a look at two such options.
Registered retirement savings plans (RRSPs)
You may have seen banks advertise about RRSPs, typically in January and February. That’s around the deadline for Canadians to contribute to these accounts in order to use them for the previous tax year.
So what are RRSPs and why should you consider contributing to one?
RRSPs can be used to reduce your current income tax burden and grow your savings for retirement. Any Canadian who has “earned income” (salary, wages, or rental income) can open an RRSP through a qualified financial institution. Every year, you’re allowed to contribute 18% of your earned income, or a specified amount, whichever is less (in 2016, the specified amount is $25,370).
That amount can then be deducted from your taxable income, which reduces the tax you’ll have to pay the government. For example, if your taxable income is $40,000, and you’re able to make a $5,000 RRSP contribution, your taxable income is then reduced to $35,000. In some cases, it will mean that you’ll fall into a lower tax bracket, so you’ll pay even less in taxes.
Before contributing to an RRSP, you have to decide how to invest the money.
There are a variety of investments the government allows you to hold in an RRSP. These include GICs (be sure to check out the best GIC rates), stocks, bonds, and mutual funds, among others. You can also get an RRSP high-interest savings account.
The beauty of an RRSP is that so long as the money is within the account, it can grow tax-free. Even though the money is intended for retirement, you can make tax-free withdrawals from your RRSP to buy a home or to go back to school. But keep in mind that any money you take out must be deposited back into your account or it’ll be considered taxable income.
Tax-free savings accounts (TFSAs)
RRSPs allow you to defer tax and build up your savings in the meantime. Tax-free savings accounts are similar, but they work a bit differently. With a TFSA, every Canadian 18 and older may contribute a specified amount of money into this account (In 2016, the amount is $5,500). You may also use up any room from previous years that you did not take advantage of. Just because you didn’t contribute in one year does not mean you’ve lost out. As with RRSPs, you’re permitted to invest TFSA money in a wide variety of products. Stocks, bonds, and mutual funds are some of the most common investments people make.
RRSPs are geared for retirement, but TFSAs can be used for whatever you’d like. You can see it as a parallel retirement savings plan if you wish. But you can also use your TFSA to save for an emergency or for something specific like a new car or a trip. And because the money you contribute has already been taxed, there’s no tax payable once you withdraw money from your account.
Start early and keep at it
There’s no time like the present when it comes to contributing to TFSAs and RRSPs. The earlier you open one of these accounts, the faster you’ll be able to grow your investments. And with RRSPs, you’ll be able to use your contributions as a tax deduction, so it’s win-win.