Some readers of this blog have asked me on different occasions what investment accounts they should invest in and when to utilize a registered vs. a non-registered account.
Should I put money in my RRSP or first maximize my TFSA?
What is the difference between registered and non-registered accounts and what are the advantages/disadvantages of choosing one over the other?
While Canadians generally recognize that they should be putting money aside for retirement, their kid’s education, and so on, a variety of account choices (and individual financial circumstances) means they may need to pick one or a combination of accounts.
Registered vs. Non-Registered Investment Accounts
A registered account is an investment account that is given tax-deferred or tax-sheltered status by the government. Income earned on the account is not taxed until withdrawal or in the case of a TFSA, is never subject to taxation.
In order to ensure that registered accounts are used for their intended purposes, the government puts rules in place that must be followed if an investor wants to avoid getting penalized. Examples of registered accounts in Canada include RRSP, RESP, TFSA, and RRIF.
A non-registered account does not enjoy the same tax-sheltered status as its registered counterpart. They are a general investment account where you can invest in a wide-rage of assets and are required to pay taxes annually on income generated by the account.
Choosing Between a Registered vs. Non-Registered Account
The choice between a registered account vs. a non-registered one depends on a host of factors, including:
- Your marginal tax rate now and in retirement
- The types of assets you plan to invest in
- The nature of returns (dividends, capital gains, interest income)
- The amount you plan to invest and your investing purpose (retirement savings, short-term project funding, kid’s college tuition)
- Whether you have maxed out your registered plans
- Age limits for the account, if applicable
Registered Retirement Savings Plan (RRSP)
Each year you can make contributions to an RRSP based on a percentage of your previous year’s earned income and up to a maximum amount. Your contribution amount lowers your taxable income, resulting in tax savings (tax refund).
Income earned on your account is tax-deferred until you start making withdrawals from the account in retirement. At this time, tax is due at your marginal tax rate, which is likely to be lower than what it was during your working years.
When you make withdrawals from your RRSP (outside of the Home Buyers’ or Lifelong Learning Plans), you lose that portion of your contribution room permanently. Unused contribution room can be carried forward indefinitely, and there are penalties for contributing more than you are allowed.
Since income earned on your RRSP continues to compound tax-free, these additional funds can significantly amplify your portfolio returns over time, making the RRSP a great account to grow your retirement pot.
- Most assets work well in an RRSP account. Income-producing assets such as fixed-income securities (bonds) and term deposits (GICs and High-Interest Savings Accounts) are particularly great in RRSP accounts. Because interest income is taxed at your marginal tax rate, it is unfavourable to hold income-generating assets outside a registered plan.
- The greatest benefit is obtained from your RRSP when your marginal tax rate is higher now than it is during withdrawal (or retirement). When you reinvest the tax refund generated by your RRSP contributions, your tax savings and portfolio growth are maximized.
- RRSPs allow you to invest in a spousal account that can be part of an income-splitting strategy to lower your overall family tax burden in retirement.
- Assets held within an RRSP account can be easily re-balanced without having to track capital gains/losses, adjusted cost bases, and the associated tax implications.
- If RRSP assets remain when the plan holder dies, they can be transferred on a tax-deferred basis to an eligible beneficiary.
- The restrictions and penalties associated with an RRSP account may make it easier for less-disciplined investors to stay the course and save for retirement.
Tax-Free Savings Account (TFSA)
Starting in 2009, the government allowed all eligible individuals over 18 years of age to invest up to a certain amount per year ($6,000 in 2022) in a tax-free account. Your TFSA contribution amount does not generate a tax refund.
Like the RRSP, unused TFSA contribution room can also be carried forward indefinitely. However, unlike the RRSP, withdrawals from a TFSA can be re-contributed at a later date.
There is no tax liability when you withdraw funds from your TFSA account, i.e. no tax is payable on income generated by the account. There are penalties for over-contributing to your TFSA.
- Income-producing assets can also be held within a TFSA account to avoid the higher tax rate levied on interest income compared to capital gains and dividends.
- If you are investing/saving money that you plan to withdraw in the short-term (for a home down payment, vacation, emergency funds), a TFSA may be preferable to save on taxes. You can also re-contribute the amount withdrawn as early as the year following the year of withdrawal.
- Want to hold foreign stocks that pay dividends? Apart from the foreign country’s withholding tax, you will not have to pay additional taxes in Canada when they are held within a TFSA.
- OAS Clawback: Income from a TFSA will not count towards the threshold amount at which the government starts to claw back your OAS pension.
- If you do not have “earned” income to generate the RRSP contribution room, a TFSA allows you to save/invest in a registered tax-deferred account using funds sourced from anywhere.
- In most cases, lower-income individuals should first maximize their TFSA before RRSP since their “tax refund” benefit is much lower due to a lower marginal tax rate. In addition, any income from their TFSA will not count towards GIS eligibility in retirement.
Related: All You Need to Know About the TFSA
Registered Education Savings Plan (RESP)
This is an account set up to save for your child’s post-secondary education.
To encourage parents/guardians to plan for their kid’s future studies, the government sweetens the deal by chipping in 20 cents for every $1 contribution you make, up to a maximum of $500 in grants per year (and a lifetime maximum of $7,200). This grant is made available through the Canada Education Savings Plan (CESG).
Additional grants are available via the a-CESG and Canada Learning Bond. You can invest up to a maximum of $50,000 per child in an RESP.
RESP contributions are not tax-deductible. Income earned on the account is tax-deferred until your child starts to make withdrawals to pay for college. The money withdrawn is then taxed in their hands at a lower tax rate.
- The free government grants guarantee you 20% or more in returns on your RESP investment as soon as they are received!
- If your child chooses not to further their education after high school, you have a few choices on what to do with the accumulated funds.
- Here are some options for investing RESP funds.
Related: All You Need to Know About the RESP
Non-Registered Investment Account
Non-registered accounts have their place in your overall investing strategy.
- If you have already maxed out your registered accounts, a non-registered account helps you to continue investing.
- If you use leverage (loans) to invest, you can deduct any associated interest expense incurred on the loan from income earned before accounting for taxes.
- You can keep investments that generate eligible Canadian dividends and capital gains in your non-registered account. Although these are taxed annually, capital gains and dividends are taxed more favourably than interest income.
- There is more flexibility in a non-registered account – no contribution or withdrawal limits.
- Unlike an RRSP that has to be collapsed when you reach 71 years of age, a non-registered account has no such restrictions.
- You can use capital gains to offset capital losses. Technically, depending on the assets held, you can also defer capital gains indefinitely until whenever you sell your asset holdings.
- Non-registered assets are deemed to be disposed of at the time of death and are taxed accordingly. Unrealized capital gains may be rolled over to an eligible beneficiary (e.g. spouse or common-law partner) and taxed in their hands.
- The investor needs to keep track of transaction costs, capital gains and losses in order to determine their income-tax liability at tax time.
In my opinion, the most ideal situation would be one in which an investor owns both registered and non-registered accounts.
You max out your registered (RRSP, TFSA, and RESP) accounts and still have funds invested within a non-registered plan. Of course, not many people have enough funds to put into all these investment “buckets.”
A young and new entrant into the workforce who is starting out on an entry-level salary may want to use up their TFSA room before contributing to an RRSP (except in a scenario where they have an employer-matching pension plan).
A senior who is nearing retirement and whose income may qualify them for GIS should consider investing in a TFSA which would not count towards the income threshold. Non-taxable income from a TFSA can also limit how much OAS is clawed back.
Seniors over the age of 71 can no longer contribute to an RRSP, but a TFSA or non-registered account can still be utilized.
An investor with all three accounts (RRSP, TFSA, and non-registered) can look at keeping their income-earning assets within a TFSA/RRSP and assets that generate capital gains/dividends within a non-registered account or TFSA in order to minimize their overall tax liability.
Accounting for income, dividends, and capital gains for tax purposes can get complicated really quickly. Investors who cannot be bothered with tracking adjusted cost bases (ACB) and the likes would find investing within registered accounts to be easy peasy.
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