Overview
Before purchasing any sort of investment product (stocks, bonds, ETFs, etc.) you will first need an investment account: an account where your financial assets will be held.
In Canada, investment accounts are split into two major categories: registered and non-registered. We will review the differences between these two account types and the specific accounts in each category.
The type of account an investor decides to go with is very important because it can have a number of consequences. These consequences include tax implications, the types of financial assets that can be held, and even certain conditions on how to interact with the account, to name a few.
Before an investor can perform any sort of investment-related activities, the first step is choosing an appropriate investment account. This article will go over some of the account options available to Canadian investors.
Registered Accounts
A registered investment account allows investors to utilize tax privileges offered by the Canadian government, such as any investment earnings being exempt from taxes.
The disadvantage virtually all registered accounts face is the fact that tax privileges can only be enjoyed if the investor follows certain conditions, such as staying within a yearly contribution limit or not withdrawing any funds from the account until a certain time.
Exceeding the contribution limit or withdrawing funds from an account too early may result in penalties. For example, over contributing may result in these excess funds being subjected to taxes.
Some registered accounts that investors may choose to go with are discussed below.
Tax-Free Savings Account (TFSA)
First introduced in 2009, Tax-Free Savings Accounts (TFSAs) allow individuals 18 and older to set money aside and allow it to grow tax-free (within defined limits). The greatest advantage of a TFSA, as the name implies, is tax savings.
If you do not overcontribute to your TFSA, any interest & dividend payments, as well as capital gains, will not be taxed. A TFSA may be an attractive option for young investors who do not plan to invest significant sums of money every year.
“Tax-Free Savings Account” is a slight misnomer since you can hold different asset classes in it other than cash.
Besides cash, a TFSA can hold mutual funds, stocks, GICs, and bonds. Foreign funds can also be contributed to a TFSA, but the Canadian dollar amount of the foreign funds contributed cannot exceed your contribution limit.
On your 18th birthday, your TFSA contribution room for a given year begins to accumulate, even if you do not open a TFSA or file income tax.
For example, you turn 18 in 2016, and you want to know your contribution room in 2020. The contribution limit from 2016 to 2018 was $5,500, and the limit for 2019 and 2020 is $6,000 (Source for the contribution limits for a given year).
Therefore, your contribution limit as of 2020 is $28,500. ($5,500 + $5,500 + $5,500 + $6,000 + $6,000).
Registered Retirement Savings Plan (RRSP)
First introduced in 1957 as part of the Canadian Income Tax Act, an RRSP allows employees and self-employed Canadians to accumulate funds for retirement, accomplished through saving and investing in an RRSP.
Pre-tax money (money an individual has before taxes are applied) is put in an RRSP and grows tax-free. Once the first withdrawal from an RRSP is made, taxes are applied.
Generally, RRSPs offer two main tax advantages. The first advantage is that contributions are tax-deductible, which depends on your income tax bracket.
Let’s say your tax rate is 40%; so, for every $1,000 you contribute, you can deduct $400 in that tax year’s income tax. Any unused contribution space is forwarded to future tax years, allowing you to save more on taxes should you find yourself in a higher tax bracket.
The second advantage is that any investment growth in an RRSP is tax-sheltered. Like a TFSA, returns are exempt from capital gains, dividends, and income tax. Contribution limits are set as a percentage of earned income, up to a maximum dollar amount.
Like TFSAs, RRSPs can hold a variety of different asset classes such as cash, stocks, bonds, ETFs, mutual funds, and foreign currencies.
Registered Retirement Income Fund (RRIF) & Registered Education Savings Plan (RESP)
There are two other commonly used registered accounts: RRIFs and RESPs. The reason we will go over both together is that they are not usually used as investment accounts for young investors, but for the sake of completion, we will briefly touch on what each account has to offer.
An RRIF can be thought of as an older sibling of an RRSP. By law, you must convert your RRSP savings into some sort of income by December 31 in the year you turn 71.
Simply converting your RRSP savings into cash usually leaves you with a huge tax bill, so to avoid that retirees can use an RRIF.
RRIFs allow retirees to withdraw funds, while still allowing their investments to grow. Taxes now apply to your investments but can now be deferred (instead of being completely shielded like an RRSP).
Because of how an RRIF is set up, this registered account will be of little interest to the young investor who is decades away from retiring.
An RESP is meant to accumulate enough money to pay for your child/children’s post-secondary education. Like an RRSP and TFSA, any investments held inside the account are shielded from capital gains and dividend taxes, as long as you stay within your yearly limit.
Assuming you are a young investor with no children, it makes little to no sense to have an RESP (at least for now).
Non-Registered Accounts
A non-registered account is an investment account not offered by the government, and as a result, does not have the same tax advantages that registered accounts do.
However, non-registered accounts offer a lot more flexibility by providing consistent liquidity (can turn your assets to cash whenever you want), and no contribution limits.
Dividends are taxed but your tax burden can be reduced thanks to dividend tax credits available to non-registered account holders. Non-registered accounts can be used in conjunction with registered accounts if an investor wants.
There are two types of non-registered accounts: cash and margin.
Cash Account
As the name implies, a cash account allows investors to purchase investment products with their own cash. Generally, an investor has access to almost all types of investment products (stocks, bonds, ETFs, mutual funds, options, etc.).
However, this doesn’t mean a cash account is all-powerful, at least, not for every investor. The types of investment products an investor can purchase are limited by the type of investor they are.
Margin Account
If you want to enhance your returns and are extremely confident in your ability to detect good investment opportunities, then a margin account may be a suitable option.
In a margin account, your brokerage lends you money (with a corresponding interest rate); this loan is usually secured, the collateral being the investor’s own assets, such as shares.
This borrowed money (i.e., the margin) is then used to make investments, sometimes in addition to an investor’s own cash.
The hope is that the investments they purchase increase in value, so they proceed to sell, thereby allowing the investor to repay their brokerage the borrowed funds while also being able to pocket some of the proceeds as well.
Be careful when using margin accounts: large investment losses may make it difficult to repay your broker, forcing you to sell some of your financial assets in order to cough up enough funds to repay.
Wrapping Up
Before purchasing any investment products, an investor should know the options available to them when it comes to selecting an appropriate investment account.
Canadian investment accounts fall into two major categories: registered and non-registered. Each category offers certain features that appeal to the needs of different investors.
The first step of achieving investment success is using the right investment account. Doing so will help ensure an investor’s portfolio grows in the most efficient way possible.
