One of the first decisions to make when saving and investing is what type(s) of account to open. Most account types can hold most investments, so the decision is based on the tax implications. Below, I give a brief description of each type of account, along with the taxation of contributions, transactions and withdrawals. I conclude with some advice about the priority that should be given to each account type.
If your employer offers any kind of pension program, there should be no difficulty in deciding to participate. Pension plans will usually include some kind of employer contribution. In some plans, only the employer contributes, in others, the employer contributions are calculated based on the amount of employee contributions. Because of this feature, there is an element of “free money” that makes it smart to participate. Further, contributions are generally made pre-tax (deductible). This means that the employer withholds less tax and you have more money to contribute than if you contributed a portion of your paycheque to a savings account.
A tax deferred account offers a tax deduction for contributions. This is a useful program, as long as your income is taxable and you expect to be in a lower tax bracket in retirement. Using this type of account especially makes sense after earning a certain amount of income, as high as $41,000. For a person earning a low income, the tax savings might be minimal and cause increased taxation in retirement, entirely offsetting the benefit. On the other hand, it could reduce your income to a level where you qualify for government programs. Consult a professional or read through the tax forms to determine if it makes sense for you.
In Canada, there is a government grant program for the RESP account, which isn’t available in the Coverdell ESA. As long as there is “free money”, it makes sense to take advantage of this program. But, first and foremost, a parent should ensure their own financial security before donating funds to children. I like the analogy of the oxygen mask in the airplane, “Adjust your own mask before assisting those travelling with you.” Think about it: if you pass out from lack of oxygen, you can’t be helpful to anyone. The next account type offers more flexibility and could be used to save for education expenses, or any other future need.
If your income in retirement will put you in the same tax bracket (or higher) as now, this makes more sense than a tax deferred account. If you remain in the same tax bracket, then with either account type, you will have the same amount of after tax proceeds. The difference is that the this account type won’t land you with a tax bill when you make a withdrawal. This is a very useful account for avoiding the taxation that might otherwise be triggered by transactions in the account (eg. interest and dividends received, capital gains tax).
Repaying debt is not an account type, but it fits in this section because of the decision of where best to allocate your funds. If you have multiple debts, you are usually financial better off to first pay down non-deductible debt. For example, credit card debt at 8% costs you more than deductible debt at 8%, because of the tax deduction. Next, you should compare interest cost to expected investment returns. If you expect your investments to earn more than 8% over the next year, as an example, you would do well to allocate funds to investments rather than debt reduction. However, if you expect your investments to return the same as your interest cost, you would be better served by reducing debt, for the stability it adds.
Because there are limits imposed on contributions to each account type each year, you will probably use more than one type. Your priority depends upon your situation, but the following is a guideline. The pension is the first priority, simplest and usually most rewarding, due to employer contributions. If your income level puts you in a higher tax bracket, you have contribution room and additional funds, you would maximise your contribution to your tax deferred (RRSP/IRA) account. If you have additional funds and college-bound children, an education saving plan makes sense, up to the limit that you receive matching. A tax-free account is most flexible and especially useful for investment accounts where it can shelter tax otherwise arising from transactions. Finally, debt repayment is important, but usually the least financially beneficial. The exception is in the case of high, non-deductible interest costs (eg. consumer loans, credit card debt).