Posted by If ‘saving money’ is the first step towards financial freedom, then ‘contributing savings to the right accounts’ is the next important step.
Everyone would love to max out every tax-advantaged account, grow taxable accounts and repay mortgage all at the same time. But cash is limited, so contributions should be prioritized into the right accounts to grow your wealth.
I think about the prioritization like a tower of champagne glasses. As the top glass is full, the second row of glasses starts to fill up. Similarly, as the highest priority investment account is filled, the money is funnelled into the next priority account.
For the average Canadian household, the contribution “tower” could look something like this:
1. Employer-matched accounts
Some employers match a certain percentage of investment contributions that employees make into investment accounts. This could be Defined Contribution Pension Plans or direct investments into RRSP/TFSA accounts not managed through the employer.
My employer matches dollar-for-dollar into a DC Pension Plan, up to a maximum annual amount. My partner’s employer doubles the amount that the employee invests. So my partner contributes a dollar and his employer contributes two dollars, with no dollar maximum per year.
Employer matching in any proportion is effectively free money, an immediate return on your investment on Day 1 of your contributions. If you are short on excess funds and can only contribute to one account, employer-matched accounts should be the number one priority.
2. Employer Stock Purchase Plans (ESPP)
If you work for a publicly traded company, your employer may offer “Employer Stock Purchase Plans”. ESPPs provide employees with incentives or discounts to purchase the employer’s publicly traded shares.
As an example, my employer offers a 25% free top-up. For each unit of share I purchase, my employer adds 0.25 share for free. This means I receive 25% bump in my investment value immediately.
I would rank ESPPs as number two in the contribution funnel, but with a big caveat. Buying stocks in individual companies, albeit your own employer, is no different than stock picking.
Since your stock investment and employment income are both tied to the success of one company, the risk is arguably higher. Despite having incentives or discounts on stock purchase, the “margin of safety” may not be sufficient given the risk.
A simple question to ask yourself: “Would I buy this stock if I didn’t have the ESPP incentive?” If you wouldn’t invest in it as a non-employee, then it makes little sense to buy stocks just to get the ESPP benefits.
Given all that, why would I rank ESPPs this high?
There are some characteristics which would make ESPPs a good option:
- Your employer is a blue-chip company that pays steady dividends
- Your employer’s incentives or discount on purchase price is very high
- Limited restrictions on the sale of shares (e.g., no/short blackout periods, permits multiple selling/liquidation events per year)
I participate in my company’s ESPP, as the company is a blue chip dividend payer in a recession-proof industry. My partner does not participate in the ESPP, as his company is a non-dividend payer in a volatile industry, so the incentive is difficult to offset the investment risk. So depending on your situation, ESPP could be ranked as high as #2 or could be the lowest priority.
3. Tax Free Savings Account (TFSA)
TFSA is probably the next best bet for the average Canadian:
- Any gains (or losses) are not subject to tax within TFSAs, so your investments can grow tax-free
- Funds within a TFSA can be withdrawn anytime without penalty, so this is beneficial for investors that don’t want to lock in funds (e.g., saving for a downpayment)
- Funds withdrawn from a TFSA is not considered taxable income and is beneficial for seniors who are looking to maximize payments from Old Age Security or Guaranteed Income Supplement from the government
Unless you are fairly certain that your future marginal tax rate will be lower in the future, then TFSAs would make the most sense for most Canadians.
4. Registered Retirement Savings Plan (RRSP)
RRSPs are a great tool to manage your taxable income. A few good uses of this account:
- RRSPs are beneficial if your current marginal tax rate is higher than your future marginal tax rate. You will get a bigger refund cheque today that you can reinvest immediately to grow your investments
- A recent pay raise or bonus has bumped you into a significantly higher marginal tax rate and you want to reduce your taxable income to a lower marginal tax bracket
- Some government benefits are based off of taxable income, so you want to be reduce your taxable income to be eligible for the benefits
The biggest mistake for those just entering the workforce is to immediately contribute to RRSPs. “Contribute to your RRSP” is a common advice, but it is not true for everyone.
For those just starting to work, you are likely earning a low salary compared to what you could earn in the future. At a low salary and a correspondingly low personal tax rate, the tax refund benefits of the RRSP is low.
Read more on how to “maximize tax deferrals within an RRSP to save money” to see why I’ve prioritized this comparatively low in the contribution funnel.
5. Registered Education Savings Plan (RESP)
RESPs benefit from a government top-up in the form of CESG (Canada Education Savings Grant), where the government will add another $500 on up to $2,500 of contributions each year. A child is eligible for up to $7,200 of CESG in their lifetime.
Why have I ranked the RESP after the RRSP? Why am I not prioritizing free money?
Overall, I am a big proponent of making sure your retirement funds are adequate before addressing your child(ren)’s RESPs. You don’t want to be a burden on your kids in your old age.
This is especially important if you had children later in life. You may be retiring when your kids are just joining the workforce or still in school.
However, I would never suggest turning down free money from the government! One could prioritize RRSP first, and use the RRSP tax refund to invest in RESP. This allows you to grow your retirement funds, while still getting 20% of free CESG. This assumes you have made sufficient RRSP contributions to get a $2,500 tax refund.
6. Taxable Investments or Mortgage Repayment
If you still have cash after making all of the above, then congratulations!
You are in an very enviable state of having to make a difficult choice between investing in a taxable account or repaying a mortgage.
This choice is less clear cut than the others. I’ll write a separate post in the future on how to decide between mortgage repayment vs. investing.
Personal finance is highly personal
As with all decisions in life, there is no one optimal way to direct your investments. It will vary based on your age, savings rate, you and your household’s tax rate, available contribution room in tax-preferential accounts, and employer benefits, etc.