So you made the decision to start investing - you are off to a great start! It may seem overwhelming to make that first step since there seems to be so many things to consider. What brokerage account should I go with? What investment account should I invest through? What investments should I buy? How can I invest so I can maximize after-tax income?
The very first step is to open an investment account with a brokerage. If you are in Canada, it can be as easy as opening up an investment account with your bank or through other online brokerages such as Questrade and/or WealthSimple.
A brokerage account basically holds the cash you use to buy stocks, just like how your checking account holds cash for your everyday expenses like groceries.
Once you decide the platform, you would need to open up an investment account. In Canada, you have mainly three options: Tax-Free, Tax Deferred & Taxable Accounts.
Tax-Free
In Canada, the Tax-Free Savings Account (TFSA) was introduced by the government starting in 2009. If you were over the age of 18 years old, you can start contributing to the TFSA based on the contribution limit for the given year (refer to summary). So, if you turned 18 in 2009, your cumulative contribution room is $75,500! This means that you can invest up to $75,500 and no matter how much your invest grows, it won't be subject to tax! So if your investment becomes $1,000,000 in your TFSA, none of that would be subject to tax!
Another benefit of the TFSA is that you can withdraw your money anytime without any penalties - the only catch is that you have to wait until next year to make the same contribution if you have already maxed out your cumulative limit. Again, if you turned 18 in 2021 and you contributed $6,000 to your TFSA up to your contribution limit, if you happen to withdraw that money during the year, you can't reinvest until the following calendar year.
Of course, there are a couple of rules you need to be careful about. For one, you can't be actively trading in your TFSA or the Canadian Revenue Agency (ie. CRA) will view it as a business and you may be subject to taxes. As long as you limit the number of trades per year and your intent is to invest long-term, you should be fine.
In order to take advantage of the TFSA, you would also need to be a resident of Canada for tax purposes. And make sure to NOT OVER CONTRIBUTE, as you may be subject to a penalty of 1% per month!
The main benefit of a TFSA is that any income you earn on your investments - whether dividends, interest income, or capital gains, are not subject to taxes in Canada. At the same time, if you make losses in your investment, you also can't claim losses on your tax return.
Tax Deferred
Another popular investment account is the Registered Retirement Savings Plan (RRSP). It is an account that helps Canadians save for retirement and the CRA provides additional tax advantages to motivate you to make contributions. For one thing, contributions made to an RRSP are tax deductible.
For example, if you contributed $1000 during the year, than you can also deduct $1000 from your taxable income (ie. not pay taxes on $1000 of your income). Depending on your marginal tax rate (refer to table), your tax savings may vary. If you make between $42,184 and $49,020, the combined Federal and BC marginal tax rate is 22.70%. This means that deducting $1000 from your income means you "save" $227 on taxes!
Another benefit is that any growth in your RRSP account, such as capital gains, interest, and dividends are also tax-free!
The catch here is that you will be taxed only when you withdraw from your RRSP. The incentive is to let your RRSP grow until retirement, when your marginal tax rate is expected to be lower compared to when you are making active income. So if you end up withdrawing sooner than that, you basically have to "pay back" the taxes that you saved when you made the initial contribution.
So can you make an unlimited contribution to your RRSP? Nope! You are limited by 18% of your earned income in the previous year, up to a maximum amount of $29,210 (2021 figure, gets updated for inflation annually). So if you over contributed beyond your limit, you will be dinged with a hefty penalty of 1% per month.
Another bonus tip is if you want to make investments in US stocks, investing through your RRSP is preferred over your TFSA account, which applies a non-resident 15% withholding tax for dividends.
Taxable
The other option to invest in a regular account, where all income from capital gains, interest, and dividend is taxed. Ususally, a taxable account is used after maxing out your TFSA and RRSP account. Another reason to use a taxable account is you actively trade and want to take advantage of more advanced investment options like margin accounts.
Disclaimer: Note this post is not accounting nor tax advice and should be used for entertainment purposes only. Consult with your own accountant and/or tax advisor for specific advice related to your business situation and needs.
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