I received an email from a reader with a bright financial future. She has both her RRSP and TFSA maxed out and wondering what to do next.
First of all, thank you for sharing your wisdom and financial journey. I love reading your blog and I learn so much from it!
I was wondering if you could give me some advice on where to put my money after maxing out my RRSP and TFSA contributions. I saw on your website that you suggested Horizons as a tax-efficient fund. I’ve read that others put it in Canadian dividend stocks. There are so many options out there, so frankly, I’m getting quite confused.
I’ve also always done our taxes just it’s just basically filling out forms. I’m worried that when I start investing our extra funds in a non-registered account, it will be a disaster come tax time. Would welcome any insight you have on this.
To start, more details are needed such as, what other assets does she have? Does have a defined benefit pension? Does her spouse have a defined benefit pension (if she has one)? Are they considered high income?
Without those details, I’m going to make the response a little more broad with the benefit of applying to more readers.
The Basics of RRSPs and TFSA and Taxation
For people new to investing, RRSP’s and TFSAs are a type of account, not an investment type. You buy investments to put in these accounts. These accounts allow investments to grow tax-free which means the investments do not need to be reported when you file for your taxes.
There are still major differences between the two accounts. RRSP deposits give you a tax deduction, but you will be taxed at your marginal rate when you withdraw. The main strategy around using an RRSP is to maximize your deposits when/if you are a high earner/highest tax bracket, and withdraw when you are in a lower tax bracket during retirement.
TFSA’s, on the other hand, do not give you a tax deduction on your deposits, but the account will let you withdraw from the account without reporting the income (ie. tax-free withdrawals). This can come as a big tax advantage for those with defined benefit pension or other retirees with higher base income. If the whole idea of TFSAs is a bit new to you, find out more about TFSAs here.
TFSA or RRSP?
Which is better? I would say for most Canadians, it’s in their best interest to max out their TFSA before going after your RRSP – especially those with lower to average income. For government workers with a defined benefit pension, no doubt TFSA is better due to higher income during retirement. For high-income earners in top tax brackets, RRSP’s may work out better providing that they re-invest their RRSP deposit tax refund.
Keep your Tax Shelter Going
Back to the point of the article, RRSP’s and TFSA’s can be powerful wealth generators as it eliminates a big investment drag – taxes! The best move for most investors is to maximize tax-sheltered accounts before investing within non-registered, or taxable, accounts.
What if both the RRSP and TFSA are maxed out like in the reader’s case? It looks like the reader has done a great job with her savings to maximize her RRSP and her TFSA and looking to possibly invest the surplus cash flow. Judging by the email, she’s also interested in keeping taxes as simple as possible.
To do that, I would suggest a couple of options before even considering investing within a non-registered/taxable account. To keep things as tax efficient as possible, I would look at other efficient ways to spend excess cash flow.
To start, an obvious one, pay down debt. If there is an existing mortgage or other debt, it would make sense at this point to take the extra cash flow to pay it down. Even though interest rates are relatively low right now, it’s a guaranteed after-tax return, and rates will likely be higher during renewal time. After all, one big milestone to achieve before retirement is to be 100% debt free.
Another option to consider if the reader has children is a registered education savings plan (RESP). This is another type of account that allows investments to grow tax-free. While there is no tax-refund for deposits, taxes are paid by the student (which should be low) when the funds are withdrawn for post-secondary education.
If all debt is paid off, and the RESP is maxed out and you still have extra cash flow – then it’s time to look at non-registered investments. That’s a big topic in itself, so let’s dig in a little.
Let’s dig into the good stuff – investing! I like to configure my accounts as one big portfolio to help minimize taxation. If you are like the reader with both RRSP and TFSA maxed out and looking to invest, you may need to re-arrange your investments to fit the “one big portfolio”.
I use the following setup for maximum tax efficiency (see this article for more detail on setting up a tax-efficient portfolio):
Here is an example of an index investor with a simple portfolio that may consist of globally diversified index funds/ETFs, bonds, and cash.
- Fixed Income/Bonds/GIC’s
- Foreign Equities
- Income Trusts
- Canadian Equities
- Fixed Income/Bonds/GIC’s
- Income Trusts
- Canadian Equities
- Foreign Equity (withholding tax on dividends will apply)*
- Canadian Equities (only if tax-sheltered accounts maxed out)
As you can see, it may make sense to pull all Canadian equities out of your tax-sheltered accounts and place in the new non-registered/taxable account due to the tax efficiency of Canadian dividends. You can read more about the tax efficiency of Canadian dividends here.
Fixed income and international dividends are taxed at 100% of your marginal rate (inefficient) which is why it makes sense to keep them tax sheltered.
Defined Benefit Pension
If you have a big defined benefit pension to look forward to in retirement, you’ll need to keep an eye on the old age security (OAS) clawback threshold.
In 2019, that threshold is around $77k. Depending on your pension income in retirement, it makes sense to max out your TFSA first as withdrawals do not count as income.
If you still have extra cash flow, pay off debt first. Once the debt is eliminated, do some careful calculations on how RRSP withdrawals will impact the OAS threshold. Otherwise, it may be a better idea to go the non-registered route with tax efficient investments.
While investing for capital gains within a non-registered account is ideal (only 50% of the gain is added to income), you’ll have to be careful of dividends as they are “grossed up”. The grossed-up amount is counted towards income thresholds like OAS during retirement. If you are interested, the article is a little dated but the core information is solid on the OAS clawback.
I think that portfolios should be diversified across multiple geographic markets, and the easiest way to do this is via index ETFs.
If you are new to ETFs, I’ve been talking a lot about the all-in-one ETFs lately as the easiest way for an investor to set up a low-cost diversified portfolio.
It gets a little trickier to use all-in-one ETFs with the “one big portfolio” concept, preferably, you’d break it up into 3 ETFs instead. For example:
- TFSA: Bond Index (VAB), Canadian REITs (VRE) and/or other high yielding Canadian equities. If you have minimal RRSP space due to a defined benefit pension, you can put your ex-Canada holdings here as well.
- RRSP: US equity, International equity, and emerging markets (XAW)
- Non-Registered: Canadian Equity (XIC or VCN)
Another option, if you like to research and follow stocks on a regular basis, is to buy Canadian dividend stocks for your non-registered portfolio while using ETFs for your ex-Canada (ie. outside Canada) exposure. At least that’s what I do for the most part.
Here is a little more info on dividend investing:
- Top 22 dividend growth stocks in Canada
- How to build a dividend growth portfolio
- My favorite discount brokers
- Knowing when to buy dividend stocks
Using Horizon’s ETFs?
For ultimate tax efficiency for the non-registered Canadian equity allocation, the reader read my article on the Horizon’s ETFs who have created index ETFs that pay 0% in distributions or dividends. Instead, you will only be taxed with capital gains tax when you sell down the road. The dividends are still there but used to compound instead of being paid out. Great deal right?
It was good while it lasted, but the last federal budget has indicated that the party is over. It hasn’t been determined how they will tax those “swap” ETFs, but there will be changes. Likely enough to make them not as attractive, which is why I would say to avoid these ETFs until there is more clarity.
If you have maxed out your tax-sheltered accounts – congratulations! The next easiest steps are to pay off all of your debt and open an RESP if you have kids.
Once the debt is eliminated (and RESP maxed out), and you are ready to set up a new non-registered account, you may need to restructure your portfolio to the “one big portfolio” concept as described above. This will involve keeping all your fixed income/REITs/ex-Canada equities tax-sheltered while moving your Canadian equity holdings out to your non-registered account.