What Are Tax-Deferred Investments?

What are tax-deferred investments?

A tax-deferred investment (also known as a registered account or tax-deferred investment plan) is an investment or savings account that allows you to postpone paying income taxes on your deposits or what you earn inside the account until you withdraw funds in the future.

How does this tax deferral work?

Usually, you’d pay taxes on your interest or investment earnings each year. For instance, if you have a high-interest savings account, the Canada Revenue Agency (CRA) expects you to report any interest earned from that account on your annual tax return. Even if you only earn a hundred bucks, it’s considered income! But with a tax-deferred plan, you won’t pay taxes on those earnings until you take out funds from your account. 

It works the same way for investment earnings, too. For example, let’s say you own stocks in a company that issues quarterly dividends. Just like interest income, if you hold those stocks outside a tax-deferred plan, you’d need to report those dividends as dividend income.

Inside a tax-deferred plan, though? You won’t pay taxes on the dividends while those funds stay in the plan.

What types of tax-deferred investments are available?

There are two types of tax-deferred plans available in Canada:

A Registered Retirement Savings Plan (RRSP)

An RRSP is a popular investment vehicle to save for retirement because it lets your investments grow tax-free until you retire. Another big plus? Your RRSP contributions are tax-deductible! 

Let’s say you make $100,000 per year. If you contribute $10,000 to your RRSP, you get to deduct that $10,000 from your yearly taxable income (as long as it’s not more than your yearly RRSP contribution room, which is the maximum amount the CRA allows you to put into your RRSP for the year). That means you’ll only have to pay taxes on $90,000 for the year:

$100,000 – $10,000 = $90,000

Of course, you’ll still have to pay taxes eventually on that $10,000 you contributed, but only when you withdraw money from your RRSP—and that won’t be until you retire.

This means you’ll most likely be in a lower tax bracket (because, hurray, you won’t have to work anymore!). Long story short: When it comes to taxes, timing is everything.

Registered Education Savings Plan (RESP)

An RESP is a great way to save for a child’s post-secondary education, and anyone can set up an RESP for a child. You don’t have to be the child’s parent.

This makes it super easy for, say, Grandma and Grandpa to set up an RESP to help fund a grandchild’s future education. As the parent, just make sure everyone stays in the loop about the total amount contributed, so you don’t hit the maximum lifetime cap of $50,000 per child.

Here’s the gist on RESPs: your contributions are made with after-tax income, so they don’t qualify for a tax deduction (sorry!).

Yes, it’s a bummer. But a big perk makes up for this: when you withdraw funds from your RESP, it’s your child who claims it on their income. And being a full-time student and all, it’s unlikely they’ll have much of an income. The result? Withdrawals from your RESP will be taxed at a much lower rate.

Plus, there’s a juicy bonus: You get free money!

With the basic Canadian Education Savings Grant (CESG), the federal government matches 20% of your yearly contributions, up to a maximum of $500 per year for each child named on the account. That adds up, and over a child’s lifetime, the government will chip in up to $7,200 of free money under the CESG. 

But wait, there’s more: lower-income families may be eligible for the Canada Learning Bond (CLB). And if you are eligible? You’re looking at getting up to $2,000 more in your account. Not a bad deal!

How does a tax-deferred account lower your taxes?

So how does this all work? Here’s how a tax-deferred account can help lower your taxes:

How does an RRSP lower your income taxes?

With an RRSP, you lower your taxes in two ways:

1. Your contributions are tax-deductible, which means your taxable income (and your taxes) will be lower.
2. You’ll only owe taxes when you withdraw the money from your plan. Since you’ll no longer be working, you’ll most likely pay fewer taxes because you’ll be in a lower tax bracket.

How does an RESP lower your income taxes?

For the person who set up the RESP, it doesn’t lower their income taxes. But there’s another benefit to the RESP: the recipient probably won’t pay any taxes on the funds later.

How does that work? The CRA says that as long as RESP fund withdrawals go toward education-related expenses, the earnings on the contributions will be taxed according to the income of the child, not the person who set up the account. 

The result? Unless the kid makes big bucks as a TikTok star, they will likely pay next to nothing in taxes on the RESP due to their lower tax bracket.

What are the advantages and disadvantages of tax-deferred investments?

By now, you’re probably itching to whip out your calculator so you can figure out how much you can contribute to a registered account. But before you dive into all the savings fun of setting up a tax-deferred investment plan, it’s a good idea to check out the advantages and disadvantages (sadly, there are some).

5 advantages of tax-deferred investments

1. Tax deferral. You get to postpone paying any tax on income earned in the account, which helps it grow.

2. Possible tax break. With an RRSP, your contributions are tax-deductible.

3. Reap the magic of compound interest. When it comes to investing, compound interest is the secret sauce. Here’s how it works: The earlier you invest in a registered savings plan, the more time your investments have to earn interest and dividend income. And that’s where the compounding magic happens. Your investments grow because this investment income gets reinvested in your account, where it will also earn income. 

4. Creditor-proof (RRSPs only). The money you put into your RRSP is generally protected from creditors’ claims, so you’re not putting your retirement at risk. And if you have to file for bankruptcy? Under federal legislation, your RRSP is still protected, subject to certain exceptions and conditions (for example, there’s a 12-month “clawback” period that exempts RRSP contributions you made in the 12 months prior to declaring bankruptcy from protection under the legislation). 

5. Tax-free withdrawals (RRSPs only). Under the Home Buyers’ Plan (HBP) or the Life Long Learning Plan (LLLP), you can withdraw money from your RRSP tax-free. But consider it a loan to yourself: the CRA expects you to repay the funds to your RRSP within 10 years for money withdrawn under the LLP and 15 years if you withdraw funds under the HBP.

5 disadvantages of tax-deferred investments

1. Contributions are capped. The CRA doesn’t allow you to stuff every cent into a tax-deferred account and reap endless rewards. With the RRSP, you can contribute up to 18% of your gross income from the previous year, up to a maximum of $29,210 in 2022 (updated annually). And while there’s no yearly maximum contribution limit for RESPs, contributions have a $50,000 lifetime cap per child.

2. The CRA will come knocking at your door someday. With RRSPs, you must withdraw your RRSP funds by the end of the year you turn 71. Most people transfer their RRSP funds into a Registered Retirement Income Fund (RRIF) at this time.

3. Your government benefits might suffer. Government retirement benefits, such as Old Age Security, are income-based. Since your RRSP withdrawals are taxable income, you may want to ensure that the amount you withdraw each year won’t increase your income to an amount that will reduce the benefits you receive. 

4. There are rules about how you can spend the funds. An RESP can only be spent on expenses associated with obtaining a post-secondary education. For example, your tuition, the cost of your textbooks, and rent. 

If you end up not using your RESP funds for post-secondary education expenses, you won’t be taxed on the amount you contributed to the RESP—but when you withdraw the funds, you’ll have to pay taxes on any money you earned in the plan. (You may not need to lose all your tax-deferral benefits, though: You can also replace the beneficiary with another child of yours, or transfer up to $50,000 tax-free to your RRSP.) And while you’re free to make early withdrawals from your RRSP unless you qualify for either the HBP or the LLLP, you’ll have to pay a withholding tax of 10-30%, depending on the amount you withdraw.

5. Strings attached. With the RESP, if your child decides not to enroll in a post-secondary institution, you’ll have to return any grant money you got from the government.

Want to take control of your investments? TurboTax Canada is here to help!

Tax-deferred investment plans offer a great incentive to save, so if you took the plunge into RRSPs or RESPs this year, congratulations! And come tax time, you can take control of your investments with TurboTax: file on your own, use our live help, or hand your taxes off to one of our experts today.