I sometimes take it for granted you the reader understand the alphabet soup of abbreviations that I use on this blog and while I do try to remember to define them in most posts I know I fail to do that once in a while.
So today I’m going to go discuss the basics of how we use Exchange Traded Funds (ETF) in our Registered Retirement Savings Plans(RRSP). But before we dig into the specifics I should do a quick over view of what those both are.
First the RRSP is just an type of investing account. The RRSP is basically a glass you can put different investments into such as bonds, stocks, mutual funds or just cash as a savings deposit. So you don’t buy an RRSP, instead you buy an investment to put in an RRSP.
The RRSP account is nice because of two main features: it gives you a tax refund and it allows your money to grow tax free. The first point most people understand in basic terms. You put money in an RRSP during the year and when you file your income tax return you let the government know about that deduction and they give you a refund on your taxes for the amount contributed. In short, if you put in $1000 into an RRSP the government pretends you earned $1000 less that year and gives you back the income tax you paid on that $1000. The rate they use is the rate you paid on your last dollar of income (other wise know as your marginal rate). If you are not sure what your rate is look it up on these tables. After the money is inside the RRSP account it then grows tax free while in there, but that is a bit of catch with RRSPs that few people understand when it come to taking the money out. When you pull the money out of the RRSP you then owe income tax on that money. Why? Basically when the RRSP allows you to defer income tax to a later time (it doesn’t let you avoid it) which is why they give you the tax refund after you put money in.
A quick aside, the Tax Free Saving Account (TFSA) is similar to an RRSP in the respect the money grows tax free. The big difference is there is no tax refund on a TFSA contribution because you don’t pay income tax when you take the money out. You don’t defer the income tax because you already paid that before you put the money inside the TFSA.
Now putting that aside, what the hell is the ETF? Basically an ETF is exactly as the name implies it is an Exchanged Traded Fund, which doesn’t make a lot of sense to most people. So in short form I tell people image a company stock and an index mutual fund had a baby, the results would be a ETF. A lot of ETFs are index based mutual funds that happened to be traded on the stock exchange like a stock. So they have a ticker symbol assigned to them and you can buy them via any self directed investment account either at a bank or a discount broker and you pay a transaction fee to do so. Of course you pay that fee each time you buy some or sell some of the ETF.
So why are ETFs things so great? In two words: low fees. I mean like VERY low in some cases. I think most Canadians understand we pay some high mutual fund management fees. Over 2% per year is common. While Vanguard’s Canadian Index (symbol VCN) management fee is a mere 0.06%. No that isn’t a typo. Yes some ETFs are higher and around 0.25% but that is still a LOT less than than 2% or higher. So by keeping your fund fees very low you end up with more money in your accounts each year and they grow faster than a typical mutual fund. The downside is the transaction fees to buy the ETF. So often people suggest you wait to change over to ETF investing until you have $25,000 to $50,000 to invest in total so your transaction fees costs don’t exceed your savings on your lower management fees. The amount you need depends somewhat how often you contribute to the account (if only once a year you can get away with the lower amount).
ETF also come in fixed income types so it is entirely possible to have your entire portfolio in ETF with rock bottom fees which is exactly what my wife and I did with our RRSP accounts. Our portfolios are dead simple and only consist of four funds. One for the Canadian stock market, one for the US stock market, one for international stocks and finally one for fixed income. We aim for 40% fixed with 20% in each of the other funds. So overall more of our money stays in our self directed accounts due to low fees and they allows them to grow a bit faster than most people.
So I hope that helps explain a bit more of how our RRSPs work with ETFs. Let me know if you have any questions.