Friday, 7 October 2011

Portfolio Allocation Primer

We all heard it before. Diversify, diversify, and diversify!  Putting all your eggs in one financial basket is just asking for trouble. By spreading out your money to different sectors of the stock market, you decrease the total risk you take on. As important as asset allocation is, portfolio allocation is just as important and I find it to be a more interesting topic. While asset allocation is used to mitigate risk, portfolio allocation is used to maximize the tax efficiency of your investments. You may know what to buy, but do you know where to put it? 
In Canada we have many different accounts we can put or hard earned cash in.  For my current situation I have three options to choose from; A RRSP or a Registered Retirement Savings Plan, a TFSA or a Tax-Free Savings Account, or an unregistered account. Another popular account is an RESP or a Registered Education Savings Plan. The last account I will not be considering since I don’t have a child and don’t plan to have one in the foreseeable future (heck, I just finished using up all the funds in the RESP that my parents set up for me)! Let’s quickly go over these accounts and how we can use them to our advantage.  
Most Canadians know what an RRSP is or at least heard the term being thrown around. RRSPs are saving vehicles that allow you to defer your taxes until you retire. Along with your investments earning everything from capital gains, interest and dividends tax free, you will also get a tax return based on how much you contribute. This is great if you believe that you will be in a lower tax bracket when you retire. The catch is that anything contributed is locked in until you retire. You can withdraw early but you’ll take a penalty. 

Tax Free Saving Accounts are fairly new, being introduced in 2009. Earnings in the account are also tax-free but you will use after-tax money to contribute. This means no tax return on contributions. The money is not locked in and can be withdrawn at any time. This flexibility alone has many Canadians using their TFSAs as a place to hold emergency funds. However, TFSAs can also be used as an investment vehicle and rivals the tried and true RRSP causing debates throughout the country about which one account to use to reach financial goals. 

Registered Education Savings Plans are used to fund post-secondary education for your children. This is another tax-sheltered account and the federal government has created the Canada Education Savings Grant to help you save. The government will contribute 20% of the first $2500 in annual contributions to the RESP giving you a maximum of $500. I don't know about you but I'm always interested in free money. Especially when it's such a high return for practically no risk!

The last account is the unregistered account. Everything in these accounts will be subjected to taxes so this is really the last place to put investments.

These are only brief (very brief!) summaries of a couple investment/saving vehicles so that next time, I can talk about my plans to use these accounts to give myself an edge in accumulating wealth. 

-the Paperboy

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