Investing Series: Where to hold what funds in your retirement accounts for maximum tax efficiency (Canada)
This is a part of the Investing Series.
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This is going to get tricky because it depends on what you buy and where you decide to hold it, but I am going to try and give you a structured overview of tax advantages in each account.
Every Canadian should have 4 Main Accounts:
I’ve listed them in order of maxation:
- Registered Retirement Savings Plan (RRSP)
- Tax-Free Savings Account (TFSA)
- Investing Accounts (Non-Registered / Margin Account)
- High-Interest Savings Account
*Maxation = A new word I invented to tell you which ones you should max out first. You like?
1. Registered Retirement Savings Plan (RRSP)
Registered Tax Deferred account
Max out the money in this one FIRST.
It is the best deal out of all the 4 accounts because of its special tax-deferred status and tax-treaty powers with the U.S.
HOLD IN THIS ACCOUNT:
- Any U.S. individual stocks — you will not pay U.S. withholding taxes under the U.S.-Canada Tax Treaty
- Any U.S. index funds — you will not pay U.S. withholding taxes under the U.S.-Canada Tax Treaty
- Any mutual funds (index funds) — let them grow since you can’t touch the money until you’re 65 anyway
- Any exchange traded funds (ETFs) (index ETFs) — ditto; let them grow slowly since you can’t touch the money
DO NOT HOLD IN THIS ACCOUNT:
- High-Interest Savings or Cash / Guaranteed Investment Certificates (GICs) — This is a real waste of the account*
- Any stock for capital gains — only 50% of profits are taxed so they’re better in a TFSA or Non-Registered account
- Any stocks for dividend investing — you get a really sweet deal with dividends in terms of taxation outside!
*Invest the money. PLEASE. Invest it!!
Don’t put it just in cash, savings or GICs.
You’re just wasting a perfectly awesome tax-deferred account in doing so, and probably losing money just to inflation to boot.
2. Tax-Free Savings Account (TFSA)
Registered Tax Sheltered account
Max out the money in this one SECOND because while it isn’t as awesome as the RRSP for tax implications, it is still better than a Non-Registered account.
HOLD IN THIS ACCOUNT:
- Any Mutual Funds (Index mutual funds)
- Any ETFs (Index ETFs)
- Any Canadian stocks for capital gains or dividends
- Any U.S. stocks for capital gains — You have to pay a withholding tax of 30% but can get it reduced to 15% with a W8-BEN form as well as getting a tax credit for it (see below)
DO NOT HOLD IN THIS ACCOUNT:
- High-Interest Savings or Cash / Guaranteed Investment Certificates (GICs) — This is a real waste of a tax-sheltered account
CONSIDER THE IMPLICATIONS OF: Holding U.S. stocks or index funds that pay dividends
TFSAs are not considered to be “registered retirement accounts” under the Canada-U.S. Tax Treaty, so any dividends earned from U.S. stocks (either in index funds or held individually) are subject to a withholding tax of 30%.
You can get that U.S. withholding tax on your U.S. dividends down to 15% and then apply for a tax credit when you do your taxes.
See below for note on W8-BEN forms and filing for your year-end foreign tax credits.
3. Investing outside of RRSP / TFSA
Non-Registered, meaning it is NOT tax sheltered/deferred
You can put any money you want in this account that isn’t already in your High-Interest savings account for emergencies, day-to-day bills and the like.
HOLD IN THIS ACCOUNT:
- Any Mutual Funds (Index mutual funds)if you HAVE maxed out your RRSP with them
- Any ETFs (Index ETFs) if you HAVE maxed out your RRSP with them
- Any stock for capital gains — You only pay taxes on 50% of your capital gains (profits) and can claim the capital losses
- Any stock for dividend investing — For Canadian stocks, you get a sweet deal with dividends in terms of taxation
CONSIDER THE IMPLICATIONS OF: Holding U.S. stocks or index funds that pay dividends
TFSAs are not considered to be “registered retirement accounts” under the Canada-U.S. Tax Treaty, so any dividends earned from U.S. stocks (either in index funds or held individually) are subject to a withholding tax of 30%.
You can get that U.S. withholding tax on your U.S. dividends down to 15% and then apply for a tax credit when you do your taxes.
See below for note on W8-BEN forms and filing for your year-end foreign tax credits.
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I am with Questrade for all of the above accounts.
Use my Questrade referral ID: o0soehds and get $50 in free trades
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And finally this is the last account you should have:
4. High Interest Savings Account
Non-Registered, meaning it is NOT tax sheltered/deferred
You should have a high-interest savings account to hold cash for emergencies and daily banking.
This is where you should hold:
- Cash
- Guaranteed Investment Certificates (GICs)
- Bonds
..not in your RRSP or TFSA.
UPDATE – September 15th 2014
You should really take the time to read the comments, but just in case you’re lazy, Reader Hemgi wrote an excellent strategy for investing in the comments that I think you should all read:
My sequence of investment is the following:
1. Pay any debt that has an interest rate greater than your ROI.
2. Maximized TFSA – use it before government reduce the annual increase of $5500 or eliminate the rights to carry over what has not been used.
3. Pay your Mortgage
4. RRSP if your marginal is greater than 40%, otherwise you gonna pay more tax when you will cash it. It may be interesting to transfer money from your TFSA to RRSP on December is your income is high.
5. Non registered account.
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Psst: If you don’t already have a Tangerine account…
Use my Tangerine referral ID: 32726976S1 to get $50 for free (I get $50 too)
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U.S. Stocks and Index Funds Note for Foreign Investors
(…like for us Canadians)
You do not need to do the following for an RRSP or Registered Retirement Income Fund (RRIF) account because it is tax-free under the U.S.-Canada Tax Treaty.
1. Immediately fill out a W8-BEN form to lower dividend taxes from 30% to 15%
If you are also a foreign investor (eg. not an American citizen), you should contact your bank / brokerage and fill out a Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding.
The IRS withholds 30% (as a tax) on U.S. stocks and index funds that pay out dividends, even on foreign investors.
You can get this reduced (potentially) down to 15% if you fill out that W-8 BEN.
It has to be a form requested by your brokerage or bank (e.g. TD Bank), so I suggest contacting them and finding out how to submit this information to the IRS.
Otherwise, you’re paying extra U.S. taxes (and letting them use 15% of your money for free) on your dividends earned for nothing during the tax year.
With Questrade (where I now hold most of my investments in index fund ETFs with the occasional stock here and there), I contacted them about this and they wrote back saying:
The W8-BEN form is not required to be completed by individuals to have the withholding tax rate adjusted.
This is because only a valid ID that displays a Canadian address can be used to update the rate. All that you would be required to do is submit to us a copy of your valid Canadian Drivers license for us to adjust your with-holding tax rate.
Done.
2. File for a foreign tax credit on your year-end taxes
When you go to do your taxes, fill out Line 405 – Federal foreign tax credit with Form T2209 so that you claim that remaining 15% you have paid in foreign tax credits.
If you are with Questrade, you can find these foreign taxes paid in Questrade by doing the following:
- Click on the “My Account”
- Then on “Account Activity”
- Select your account (Margin or TFSA) to see your dividends and taxes withheld
18 Comments
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RICARDO
Not sure I agree with you on maxing the RRSP accounts first.
Although there was no option for my generation, now 64, the younger generation has many more years of contribution room left. All things being equal and maybe with a little luck from the Gods on your stock investments, a maxed out RRSP may invite clawbacks of the OAS if it is high enough to exceed the revenue limits. In other words, if you were so lucky as to have $2 million in your RRSP at 71yrs you will be obliged to withdraw over $140K that year. This would invite the clawback of the OAS.
So my thoughts for the younger generation are max out the TFSA and put the rest in the RRSP. AT least any withdrawals from the TFSA will not invite clawbacks. What happens in 30 years when the TFSA’s have grown to a fairly hefty sum and the governments are short of your tax dollars, again, is another matter. I am almost sure that the governments will be drooling when they realize how much money that is tax free could help them out. Doubt I will be around to see that.-
save. spend. splurge.
Ahhh that makes more sense. Thanks for clarifying. I didn’t really know how much you’d have to have saved in an RRSP to get an OAS clawback.
Your logic / reasoning is sound for TFSA maxing out for the younger generation. I always max out everything I have, but given the choice, the TFSA does make sense when you put it that way.
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RICARDO
Hi SSS;
Basically you can look at the mandatory withdrawal rates for RRIF’s, if you covert to a RRIF. They are 4% at 65 yrs, 7.38% at 71 (this is the mandatory age where you HAVE to convert to an annuity or RRIF) and go up to 20% when you are in your 90’s – if you are so lucky. The governments want those tax deferred dollars back!
Now the clawback starts some place around $80K.
So depending on your financial situation when you retire you will be pulling CPP/QPP (dependent on your contributions and date of retirement), OAS, any company pension should you be so lucky and then the monies you have squirreled away – RRSP, TFSA, non-registered accounts
With those financial inputs, someplace over $80 K the government will start to claw back OAS.
So while you are foregoing tax deferred savings (RRSP tax deduction) vs after tax TFSA during your contribution years, it may be more advantageous later in life to have grown the TFSA as fast as possible. And you can continue to grow your TFSA even in retirement whereas the RRSP will be shut off once you no longer have employment income.
My reasoning is that you can pull less from the RRSP at a lessor principle investment amount and complete it with any withdrawals from the TFSA if necessary.
If you have non-registered investments at the time of your retirement they can be converted/sheltered over to the TFSA to the tune of $5.5K per year at present.
Non-sheltered funds get depleted first through transfers to the TFSA and normal life spending requiremnts. DO NOT touch the RRSP’s until you have to. Once you convert to an RRIF there is no going back so you keep them sheltered as long as possible.
Now if by the luck of the Gods you inadvertently get above that $80K threshold of revenue, don’t sweat it. You will be one hell of a long way ahead of the majority of people pensioned off. And if you reach $140K of revenue, when ALL the OAS will be clawed back, then I will be very hard pressed to say _POOR YOU. LOL
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Janine
Really great post! I think this will help a lot of people that aren’t sure where they should be putting their money and don’t have the means to see a financial planner. Sometimes the financial planners don’t even know this information!
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Confused
This advice goes against the Canadian Couch Potato general wisdom that you put bonds in your TFSA/RRSP first, then equities if you have room. That would be assuming you have index fund ETFs.
Your reasoning sounds logical but since this goes against all the investing advice I’ve received so far, I am very skeptical of your approach.
Maybe you could clarify for me?
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save. spend. splurge.
Yes that’s true you should put bonds in your TFSA/RRSP if you want to avoid paying income tax on the interest earned but doing the math, I’d spend more or make more money in equities seeing as 95% of my portfolio is in equities, not bonds, and I’d rather pay the interest outside with the income tax than to save on the income tax at the cost of my equities in my margin account costing me more money in capital gains / dividends.
It all depends on your personal situation, of course. With capital gains you only pay tax on 50% of the profits earned, dividends are also taxed favourably when held outside of registered accounts..
Also, I control my own income (how much I take out / withdraw), which also helps when I see how much I have to pay in taxes on interest earned in my savings account and so on.
Did that help?
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Bridget
Great post (as always)!!
Thanks for the detail… I only recently learned about where to keep what investments, which is crazy. I’ve held US stocks in my TFSA for years, and thankfully they’ve performed SUPER well but now that I know the best options for me, I’ve been slowly getting rid of them, while adding US stocks in my RRSP.
Hard to get it all in the right place =\
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save. spend. splurge.
You’re welcome! I have U.S. stocks in my margin account only because I had to transfer my RRSPs over from another source and as a result, couldn’t choose to put U.S. stocks in there (I no longer have RRSP contribution room as I take my salary in dividends and therefore does not count as earned income).
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Morgaine
Great post! There is a LOT of debate out there about what to save in which account and which account to max out first, this is a great write up. One caveat, that I can think of, if you have a company pension you may want to think about maxing TFSA before RRSP. Otherwise, your income may be very high in retirement. Now, a lot of people would say “right, so you can still collect OAS without clawback” but I’m thinking purely from a taxation perspective. Both pension and RRSP (well, then RRIF) withdrawals are considered income when you take it no matter what the accounts were invested in, and income is taxed highest (than cap gains/dividends). Its something on my mind since I do have a company (government) defined benefit pension.
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save. spend. splurge.
That’s true. I’d agree with maxing the TFSA because it’s more versatile, but if you get a company match, the RRSP is the way to go.
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Kassandra @ More Than Just Money
Solid post! I transferred out my assets and shut down my TFSA prior to moving to the US this year in order to avoid taxation. As you mentioned, TFSA’s are not eligible for deferred taxation (based on the treaty rules). I kept my RRSP with Questrade but was required to open a new account and transfer the ETS’s in order to update my status as a non-resident Canadian. I’ll also have to file additional paperwork each year with the IRS in order to defer the taxes until I’m ready to draw down.
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ArianaAuburn
Awesome post! This post should be referenced in a college-level finance course.
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Charlotte
Ding ding ding!! SSS strikes again 🙂
These investment series posts are some of my favourites in the PF community, by far. The way you’ve broken down the info is extremely simple, understandable and actionable. I haven’t filled out on of those forms yet but it seems very easy (when the time comes). Keep these posts coming!
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save. spend. splurge.
Hahah thanks 🙂
I’m so happy they’re helping you. I really aim to try and make them as easy as possible.
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Hemgi
RRSP are great and should be maximize first only if you are paying income tax today at an higher marginal rate that you will pay when you will retired. If your marginal rate is not at 40%, it is far from an emergency to put money there.
My sequence of investment is the following:
1. Pay any debt that has an interest rate greater than your ROI.
2. Maximized TFSA – use it before government reduce the annual increase of $5500 or eliminate the rights to carry over what has not been used.
3. Pay your Mortgage
4. RRSP if your marginal is greater than 40%, otherwise you gonna pay more tax when you will cash it. It may be interesting to transfer money from your TFSA to RRSP on December is your income is high.
5. Non registered account.