Determining which account (Tax Free, Retirement, or Taxable) to hold different investment types in
Today’s post is targeted specificity at Canadians and assumes the reader is already familiar with the TFSA, RRSP, and regular taxable accounts.
There are two parts to every investment decision we make; the investment itself, and the type of account to hold that investment in. Asset allocation is important because we don’t want to put all our eggs in one basket. But asset location is also important because different types of investment incomes are taxed at different rates. Thankfully we can hold our investments in special tax advantaged accounts to shelter our profits so we don’t pay more tax than we have to. 😉
In an ideal world all of our investments would be bought inside tax advantaged accounts such as a TFSA or RRSP. There’s little reason to use a non-registered (taxable account) if there is still contribution room remaining in our tax free or registered retirement accounts. However its possible to purchase more investments than what our tax advantaged accounts will hold. If that’s the case then investment income that is typically taxed at higher rates should take priority inside a TFSA or RRSP. So with that in mind let’s get down to the nitty-gritty.
Which Investment Vehicles to use: TFSA, RRSP, or Non-Registered
Where is the best place to put stocks, bonds, mutual funds, and ETFs? Should they go in an RRSP or a TFSA? There is no categorically correct answer but here are some general guidelines that I follow.
- Use RRSPs for interest producing investments and U.S. dividend paying companies.
- Use non-registered accounts for Canadian dividend paying companies and preferred shares.
- Use TFSAs for everything else.
For a deeper look, below are two charts that go into specifics. The first chart shows how different types of investment income is taxed in different kinds of accounts for someone in the 31% marginal tax bracket. The second chart suggests the best accounts to buy different types of specific investments in. 😀
Additional notes to consider:
- If we hold U.S. dividend stocks in a taxable account we’ll pay the 15% U.S. withholding tax off the top. But we can claim a foreign tax credit on our tax returns to recover some or all of this amount. However we’ll pay tax at our marginal rate on the full amount of the U.S. dividend. The net result is that U.S. dividends held in a non-registered account will be taxed at the same rate as interest income.
- Dividend income from U.S. dividend stocks in a Tax Free Savings Account (TFSA) is also subject to the 15% withholding tax, however this tax is non-recoverable. But the remaining dividend and any capital gains is not taxed.
- Dividend income from U.S. stocks in an RRSP are exempt from the 15% withholding tax. But this only applies if we directly hold a stock or ETF traded on a U.S. exchange. If the U.S. stocks are held in a Canadian mutual fund or ETF, we will need to pay the unrecoverable 15% withholding tax on the dividends.
- Keep in mind that although many investment incomes are tax efficient while being held in an RRSP, any money withdrawn from the RRSP or RRIF later on will be subject to income tax at the full marginal rate and could trigger claw-backs for income tested government benefits like OAS.
- Tax efficiency should not be the only factor when deciding which account to put an investment into. Simplification of record keeping, personal financial situation, risk tolerance, and retirement goals all have to be considered.
- For most intents and taxation purposes RESPs behave the same way as TFSAs. RRIFs and LIRAs behave similar to RRSPs.