You’ve been investing for a while, contributing to your TFSA, and you’ve reached the contribution limit. Now what?
First off, you’re doing great. You should be proud of yourself for spending less than you earn and investing. It sounds like you have good personal finance habits and systems in place.
If you were like me, you didn’t care about taxes on investment income until this point. Taxes didn’t matter in the tax-sheltered TFSA. But now, taxes matter. Now you have skin in the game. Once your TFSA is maxed you have two options:
- Invest in the RRSP; and/or
- Invest in a taxable account.
By understanding how the TFSA works, how the RRSP works, and investments taxes, you’re set to maximize your after-tax wealth by locating investments in a specific way across your accounts.
This is called tax efficiency and it is great, but it comes at the cost of complexity.
I’ll share my approach to achieve tax efficiency once my TFSA was maxed. Note that I only invest in index equity and bond funds. My equity funds are globally diversified, while I only hold Canadian bonds.
Please note, this post is for education only. It is not advice. I am not a CFP, CFA, or tax advisor. I am also not an attorney, although I feel like one when this. Please read my disclaimer page for more. I have an MBA, engineering degree and read a lot.
Step 1 - Determine Priorities - RRSP vs. Taxable
Now that your TFSA is maxed, there are two considerations:
- What account to fill next; and
- How to allocate your investments across the various accounts.
For most, it’s best to fill the RRSP once the TFSA is maxed. There are a few cases where it can be useful to invest in a taxable account even when you have RRSP room. I’ll cover this rare circumstance below.
First, let’s cover the account priorities that will maximize after-tax wealth. There are three different possible situations.
The following account priorities will maximize after-tax wealth if your tax rate today is lower than your expected tax rate in retirement.
- TFSA First
- RRSP Second
- Taxable Account Last
The following account priorities will maximize after-tax wealth if your tax rate today is higher today than your expected tax rate in retirement.
- RRSP First
- TFSA Second
- Taxable Account Last
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When You May Want to Prioritize the Taxable Account Before the RRSP
There are cases where it is sensible to fill your taxable account before your RRSP, like this:
- TFSA First;
- Taxable Account Second; and
- RRSP Last.
I’m in this situation right now. The TFSA is maxed, I have RRSP contribution room and I am filling my taxable investment account with tax-efficient Canadian equities (using VCN).
I see two reasons why one may use taxable investments while still having RRSP room:
(1) Your tax rate today is far lower than your tax rate in retirement. Two sources of high retirement income are pension income, or dividend and capitals gain income from investments in an RRSP or taxable investment account.
(2) You expect your income to increase significantly in the future and want to save RRSP contribution room for when your tax bracket is higher.
TFSA vs. RRSP vs. Taxable Comparison Calculator
I built this calculator to help me better understand how account selection affects after tax wealth. You can download an excel copy, or make it your own in google sheets.
Step 2 - Understand Asset Location
Once you have the account priorities set, the next step is to place investments across the various accounts in a way that minimizes tax. This is called asset location – where you “locate” your assets (investments).
So, how much tax can I save with asset location? You can save around 0.5% annually over the long term by reducing foreign withholding taxes and taxes.
I will dig into the specifics of asset location in Step 4. But first, asset location comes at the cost of increased portfolio complexity. That’s why we will first look at the simple approach.
Why Simplicity is Important
Before we jump into asset location, I want to talk about simplicity.
Asset location can be complex. For example, I use the complex method and have upwards of 5 ETFs spread between my 3 accounts. This quickly becomes a headache. I only do this because investing is my hobby.
Plus, some ETFs need to be in USD in the RRSP to reduce withholding taxes, meaning you need to learn Norbert’s Gambit.
Simplicity helps you leave your portfolio alone, making it easier to detach and protect yourself from human biases that destroy returns. It also preserves your most valuable resource – time. This way, you can focus on life rather than investing.
How to Make Things Simple: One Fund Products
One-fund asset allocation ETFs remove complexity. With MERs around ~0.2%, these one-fund ETFs give you low cost, hands off, global stock and bond market exposure. The equity (stock) component of these ETFs holds underlying index funds that hold U.S, Canadian, International and Emerging Market stocks. And they automatically rebalance to retain the same geographic exposure.
The asset allocation ETF of choice can simply be placed in accounts in the order described in step 1. For example, if income today is lower than expected income in retirement, consider filling the RRSP once the TFSA is maxed.
Asset location is no longer a problem with a one-fund approach. Plus, you don’t need to re-balance every year. Each account would be filled in accordance with Step 1. Under this approach, each account would have the exact same asset mix.
Specific One Fund Products
An asset allocation ETF invests in a collection of Stock ETFs and Bond ETFs. Here are some asset allocation ETFs from Vanguard and iShares:
- Vanguard one-fund solutions include VEQT, VGRO and VBAL.
- iShares one-fund solutions include XEQT, XGRO and XBAL.
Step 3: Asset Location, the Complex Approach
Asset Location Once TFSA is Maxed: Summary
I’ll start of with my approach once the TFSA was maxed. Then we will go into the “why”.
Once the TFSA was maxed, I made sure all the tax-inefficient investments were in the TFSA. I then placed my tax-efficient Canadian stocks in my taxable account.
Note that I am unique in that I only use the RRSP for the home buyers plan. I do so because I expect my income to be much higher in retirement than today.
Securities I prioritize in my TFSA:
- High Foreign Dividend Yielding Stocks (XEF, VEE)
- Real Estate Investment Trusts (REITs)
- U.S. Stocks (VUN)
- Bonds (VAB)
Securities I place in my Taxable Account:
- Canadian Stocks (VCN) – Tax-efficient dividends
Investment Categories for Asset Location
Understanding how taxes apply to investment income empowers you to determine investment location. There are 6 separate categories of investments I like to think about separately for tax purposes:
- Canadian Stocks – High Yield, tax-efficient if you make less than $150k/yr
- U.S. Stocks – Low foreign dividend yield. Tax-efficient.
- International Stocks – High foreign dividend yield, tax-inefficient.
- Emerging Market Stocks – High foreign dividend yield, tax-inefficient.
- Bonds – High yield, tax-inefficient.
- REITs – High yield, tax-inefficient.
Tax on Investment Income
We can now learn why the different categories of investment income are tax efficient or tax in-efficient in a non-registered (taxable) account. Finally, we can cover how withholding taxes impact foreign dividends.
Read this guide on taxes for investment income if you don’t already understand how taxes apply to capital gains, Canadian dividends, foreign dividends, and withholding taxes.
A quick refresher. The three categories of income I look at for tax purposes:
- Other income includes employment income, foreign dividends, and interest income. Other income is taxed at your marginal rate – your highest tax rate. This type of income is tax-inefficient.
- Capital gains income – The difference between an asset’s purchase and sale price is capital gains income. Half of the capital gain (50%) is taxed at your marginal rate. Capital gains are tax efficient.
- Eligible dividends are dividends paid by Canadian companies and are taxed at low rates. Canadian dividends are tax-efficient, especially if your income is low.
The chart below shows the combined federal and provincial tax rates for the three core income types for those in Ontario.
Don’t live in Ontario? You can find the combined tax rates for each province here.
Combined Federal & Ontario Tax Brackets and Tax Rates Including Surtaxes
2022 Taxable Income
2022 Marginal Tax Rates
|over $46,226 up to $50,197|
|over $50,197 up to $81,411|
|over $81,411 up to $92,454|
|over $92,454 up to $95,906|
|over $95,906 up to $100,392|
|over $100,392 up to $150,000|
|over $150,000 up to $155,625|
|over $155,625 up to $220,000|
|over $200,000 up to $221,708|
This is not my chart. All credit belongs to taxtips.ca.
Most people, like myself, focus on Management Expense Ratios (MERs). But the 15% U.S withholding tax on dividends often generates even greater losses than ETF MERs.
Understanding withholding tax can save you up to 30 basis points (0.3%) annually for a portfolio of global stocks. This will equate to a 9.4% difference in portfolio value over 30 years. You can’t get away from withholding tax in a TFSA, but you can get rid of them in the RRSP.
Read Justin Bender’s White Paper on Withholding Taxes to learn more. It’s the best resource on withholding tax for Canadians. If this paper makes your brain hurt, you’re not alone. It made my brain hurt too. It’s up to you to determine if the brain pain is worth the small gain.
Asset Location Wrap Up
To understand asset location, you need to understand how taxes apply to the various types of investment income. You can read more about asset location in this PWL Capital White Paper. Let’s apply what we have learned.
Step 4: Putting It Together
Tax Efficient or Tax Inefficient?
Capital Gains (no or low yield)
2nd priority in a taxable account
1st priority in a taxable account
High Dividend Yield Foreign Stocks
RRSP can eliminate U.S. withholding taxes.
Interest Bearing Assets (Bonds)
Taxable Account: Capital Gains or Canadian Dividends?
We know capital gains and Canadian dividends are the most tax-efficient in a taxable account. But, how do we decide which one to prioritize?
Here are three things to consider when pondering capital gains income and Canadian dividends in a taxable account:
- Eligible dividends are more tax-efficient than capital gains until you start making over ~$100k/yr in taxable income. After this point, capital gains become more tax-efficient relative to dividend income. The exact threshold depends on your province.
- Dividend taxes impose a minor tax drag on the compound effect that can have a large impact on portfolio value over time. This drag doesn’t exist on zero-yield securities because they grow tax-free until you sell (and realize the capital gain).
- Your taxable income increases by 1.38% of the dividend received (the gross-up amount). This will increase taxable income and can take you into a higher tax bracket.
Including The RRSP
Because I expect a high tax bracket in retirement (military pension), I only use the RSP to hold bonds. I’ll sell the bonds when I buy a home under the Home Buyer’s Plan, when the real-estate market is such that it makes more financial sense to own rather than rent.
Holding bonds in the RRSP also leaves more room for faster-growing stocks in the TFSA. A larger TFSA account value down the road will provide tax-free income, whereas all income pulled from the RRSP will be taxed as regular income. I will maximize after-tax wealth by holding assets with higher expected returns in the TFSA should.
If I held stocks in my RRSP, I would prioritize my U.S dividend-yielding ETFs, to reduce withholding taxes. With a low U.S. dividend yield of 1.3%, I would only save 0.2% per year in U.S. withholding taxes. This 0.2% is only worthwhile if you know how to exchange currency using Norbert’s Gambit.
A Final Note: Be Cautious With Complexity
We all have a unique tolerance for investment complexity. Identify the amount of work your willing to put in for a given gain in tax efficiency. Keep in mind that greater portfolio involvement increases risk of behavioral errors.
You can check out various model portfolios at Canadian Portfolio Manager. This blog has various portfolios with differing levels of complexity. I’d own a single asset allocation ETF in all accounts if investing wasn’t my hobby.