Retirement Accounts Explained (Equivalent Canadian vs. American Accounts)

 

 

A few days ago, I saw a tweet that said “most people don’t have money problems, they have financial literacy problems,” and while I do think that’s a super simplified way to state financial literacy: I do agree with the principle of it.

Of course, there is something to be said about the challenges of making money, but a lot of money management can be really confusing.

A lot of financial literacy can be hard because of the jargon that encases retirement. Now before I start, I would like to clarify that I am not a certified financial planner or accountant. But a lot of retirement is dependent on understanding the terms, accounts, and strategy around retirement planning which is what I will be talking about today. 

Lastly, before we start, I want to be clear that I don’t work towards FIRE or significantly early retirement (I’m aiming for my 50s), but I do think retirement planning is a critical part of personal finance and the sooner you start understanding and learning about it, the better. Because retirement is planning is heavily dependent on compounding interest so the more time you have, the better.

Intimidated to start where? This everything you need to know about how to start retirement planning.

 

1. Find Your Retirement Number

Before you planning for retirement it is really important to find your retirement number and think about approximately how much money you will need for retirement. This number is not the end-all, be-all number that you MUST achieve for your retirement to be perfect, but it’s a great start and gives you a good ballpark to work towards. I recommend using a calculator like the one on Wealthsimple to get more details and account for all the factors for your personal situation.

 

2. Understand Taxes 

All retirement accounts have their own benefits, terms and penalties. But the overarching strategy behind retirement accounts is taxes. Before you start randomly adding money into retirement accounts, these are the definitions you need to be aware of

Tax-deductible: Retirement accounts that are tax-ductible means you can get tax breaks on your current income if you contribute to these types of accounts. That means that if you make 60K a year and you put 10k into a tax-deductible retirement account, your income is only taxed on the 50k. These types of accounts are great if you make lots of money now and especially if you are between tax brackets. Banks and governments create this type of account to incentivize contributing to retirement.

Tax-Deferred/Tax Sheltered: So once you place your money into a retirement account, you need to be aware of what happens when you take it out. For tax-deferred accounts, you are not taxed when you put the money into the account, but you are taxed when you take the money out (that’s what defer means). The strategy behind this type of account is that you ideally contribute into tax-deferred accounts when you are making more money, and slowly take it when you are older and making less money, so you don’t hit a tax bracket, but you still have to pay taxes. This type of account is also called tax-sheltered because you can’t be tax n this account until you remove it. 

Tax Exempt: The last one to really be aware of is tax-exempt. These are accounts that do not have any tax benefit when you contribute to them but are not taxed once you take money out of them.

 

3. Choose the best retirement accounts for you

There is no one size fits all retirement strategy. And your retirement strategy will differ depending on your lifestyle, assets, income, interest rates, and also the time in your life. Retirement planning is different when you’re 30 and when you’re 50. But it’s so important to know what accounts are out there and these are the main retirement accounts:

Canadian Pension Plan (CPP) similar to Social Security

Let’s start off with the basics: retirement that is federally funded by tax revenues. Everyone working in Canada or the US either pays CPP or Social Security because it is automatically taken off your paycheque. There is very little you can do about these contributions as these deductions are automatic. However, it is important to understand that the money deposited into these accounts are tax-deferred. This means you do pay taxes when you take out the money because it is taxable like regular income. This is super important to understand because lots of people make the mistake of relying solely on CPP or Social Security which is not nearly enough. The average CPP payout per month is $700-$1200 depending on how much you contribute etc. You can view more specific info in your Service Canada accounts, but that is not enough for even rent in most places in Canada. And, that’s taxable income, so if you do have other money coming in, this will be taxed as well. 

 

Tax-Free Savings Accou t (Similar to Roth IRA)

The TFSA and Roth IRA are tax-exempt, but not tax-deductible. That means that when you put money into these accounts, they provide no tax benefit to your current year’s income. However, the money inside is tax-exempt which means you are not taxed when you take the money out. Furthermore, if you invest in these accounts (as you should, not just save), the capital gains is also not taxed when you take the money out. The caveat to these types of accounts is they have limits. In 2021, you can tribute 6K into your TFSA in Canada or 6K into your Roth IRA in America, and have those gains grow tax-free. And that amount is also cumulative for the TFSA (I’m not sure about Roth IRA), so if you can’t contribute the full amount this year, you can have it added to your allowance next year. I opened the TFSA when it came out and right now my limit is 75K. 

This is one of the most important to accounts to max out because of the clear tax benefits, especially when you are in a lower tax bracket and can’t reap the rewards of a tax-deductible account. Also when you invest in these types of accounts at a young age, since the gains are not taxed, it pays off big when you are investing for retirement which is 20-30 years away.

 

Registered Retirement Savings Plan (RRSP) (Similar to Traditional IRA)

These accounts are super common retirement accounts and they are tax-deductible accounts and the gains are also tax-sheltered. That means that when you put money into these accounts, you will not be taxed, but you will be taxed when you withdraw. The strategy behind using these accounts is that you should put money into them when you are making a high income, so you are not heavily taxed on your income and then withdraw it slowly during retirement when your income will be less.

If you are American, there is something also called a back door or conversion Roth IRA where you can start put money into a Traditional IRA for its benefits and then convert the gains to a Roth IRA. Since I am not American, this is not applicable to me, but it’s definitely something to look into!

 

Group RRSPs (similar to 401K)

These types of accounts are usually contributed through your work. They are accounts that are tax-deductible and tax-deferred. For specific terms or conditions, it’s important to talk to your employer regarding the account details. However, the great thing about these types of accounts is that an employer usually matches your contribution up to a certain percentage, so it’s always important to max out because it is free money!

 

Company Pensions

Lastly, some companies (especially public sectors) offer pension plans, and if public service is something you I will not be talking in detail about pensions because every plan is different, even my partner and I have different pension plans but pensions are basically accounts you contribute through work (and your employer usually makes a match). When you enter retirement, depending on your years of service and pension plan terms, you are then paid a percentage of your salary for the rest of your life. Pensions are great because they can be automatically deducted, matched and guarantee a certain income in retirement. However, like many things in life, it’s not a 100% guarantee because the organization could fold, or you could change your mind about working for that one company and do not stay long enough to get the full pension benefits.

 

When looking into retirement, it’s really important to understand your retirement options. Retirement is very personal. It is very different if you choose to own a home, have kids, and what type of retirement or lifestyle you want to live. But it’s so important to save towards because you will not (and should not) be able to work forever.

Interested in knowing my retirement plan? Listen to the podcast episode for more details! Happy spending and saving!

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