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 now. 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 investment 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 nice, but it comes at the cost of complexity.
I’ll share my approach to a maxed TFSA. Note that this post discusses TFSA use with stock and bond index funds. See this post for TFSA use with short-term savings.
Finally, there are cases where a TFSA can be maxed, and you still may not be ready to invest. Here are 9 Signs You Are Ready To Invest.
Table of Contents
Step 1 - Determine Priorities - RRSP vs. TFSA vs. Taxable
Now that your TFSA is maxed, there are two considerations:
- What account to fill next; and
- How to locate investments across the various accounts to reduce taxes owed.
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 is likely to 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 is likely to 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
When You May Want to Prioritize the Taxable Account Before the RRSP
There are cases where it may be 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 investing in 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 investment income (from an RRSP or taxable investment account).
(2) Your TFSA is maxed and you expect your income to increase significantly in the future. You may want to save your RRSP contribution room for when your tax bracket is higher.
TFSA vs. RRSP vs. Taxable Comparison Calculator
I built this calculator to help you 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.
Note that asset location is different from asset allocation. Asset allocation represents your mix between stocks, bonds, and cash. Asset location speaks to the account location where you put your investments.
So, how much tax can I save with asset location? Maybe a maximum of 0.4% annually over the long term.
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 I first look at the simple approach.
Importance of Simplicity
Before we jump into asset location, I want to talk about simplicity.
Asset location can be complex. For example, I use the complex method with the Rational Reminder Value Tilt Portfolio and have upwards of 6 ETFs spread between three accounts. This can be a headache. I would not do this if investing were not my hobby.
Plus, some ETFs must be in USD in the RRSP to reduce withholding taxes, adding the complexity of using Norbert’s Gambit to reduce currency exchange fees.
Simplicity helps you leave your portfolio alone, making it easier to detach and protect yourself from human biases that hurt returns. It also preserves your most valuable resource – time. This way, you can focus on life rather than investing.
So, what is the most straightforward approach? For me, these would be an asset allocation ETF.
How to Maximize Simplicity: Asset Allocation ETFs
One-fund asset allocation ETFs remove complexity. With MERs around ~0.2%, these one-fund ETFs give low-cost exposure to a global collection of stocks and bonds.
The equity (stock) component holds underlying index funds that cover U.S., Canadian, International and Emerging Markets. And they automatically rebalance to retain a target geographic exposure.
An asset allocation ETF that aligns with your risk tolerance can be placed in accounts in the order described in step 1. That’s it.
For example, consider Fred, who has a risk tolerance that permits a 60% stock, 40% bond portfolio. Therefore, Fred invests in the asset allocation ETF VBAL.
Fred is in his peak earning years and expects his tax rates in retirement to be far lower than his tax rates today.
Therefore, Fred fills his RRSP with VBAL and then fills his TFSA with VBAL. Once the TFSA is maxed, Fred buys VBAL in his taxable account.
Asset location is no longer a problem with a one-fund approach. Plus, you don’t need to re-balance every year. Under this approach, each account would have the same ETF and asset mix.
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Step 3: 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 put tax-inefficient investments in the TFSA. I then placed my tax-efficient Canadian stocks in my taxable account.
I am unique because I don’t use the RRSP due to a defined benefits pension.
Securities I prioritize in my TFSA:
- International Stocks (XEF)
- Emerging Market Stocks (VWO)
- U.S. Stocks (VUN)
- Bonds (VAB)
Securities I place in my Taxable Account:
- Canadian Stocks (VCN) – Tax-efficient dividends reduce tax-drag on compounding.
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
You are ready to learn why the different categories of investment income are tax-efficient or tax-inefficient in a non-registered (taxable) account. Finally, I’ll cover how withholding taxes impact foreign dividends.
I cover taxes on investment income in this guide, including 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 – Capital gains income is the difference between an asset’s purchase and sale price. Half of the capital gain (50%) is taxed at your marginal rate. Capital gains are tax efficient.
- Eligible dividends are paid by Canadian companies and 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. 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 cannot avoid withholding tax in a TFSA, but you can avoid US withholding tax in a RRSP.
Read Justin Bender’s White Paper on Withholding Taxes to learn more. It’s the best resource for withholding tax for Canadians. If this paper makes your brain hurt, you’re not alone. It made my brain hurt too. Determining if the brain pain is worth the small gain is up to you.
Asset Location Wrap Up
Step 4: Assessment
This table summarizes how I locate my investments based on tax efficiency for each geographic asset location.
Tax Efficient or Tax Inefficient?
US Stocks (low dividend 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:
- Once you start making over ~$100k/yr in taxable income, eligible dividends become less tax-efficient than realized capital gains. After this point, realized capital gains are more tax-efficient than dividend income. The exact threshold depends on your province. The reality is that you likely won’t realize capital gains until far in the future.
- Dividend taxes impose a minor tax drag on the compound effect that can have a large impact on portfolio value over time. I show this effect in my post on S&P500 Dividends. Capital gains don’t have this problem as 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
I expect to be in a higher tax bracket in retirement (government pension + taxable investments) relative to my current tax bracket; I only use the RSP to hold bonds.
Holding bonds in the RRSP also leaves more room for assets with higher expected returns in the TFSA.
A larger TFSA account value down the road can provide tax-free income, whereas all income pulled from the RRSP will be taxed as regular income. I intend to maximize after-tax wealth by holding assets with higher expected returns in the TFSA.
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. Total Market dividend yield of less than 2%, I would only save 0.3% per year in U.S. withholding taxes.
Capital Gains vs. Dividend Income
Apart from tax implications and brokerage commission fees, it doesn’t matter if you use dividends or capital gains for income.
The effect will be the same numerically, but perhaps not psychologically.
Dividends are irrelevant, a concept I cover in my post on 5 Dividend Misconceptions That Can Hurt You Financially.
Changes To Future Tax Rates
There is always a risk that tax rates will change. Under the baseline situation, tax brackets can be expected to increase with inflation.
But I’m talking about inflation-adjusted rates changing. You can consider this a risk when doing your planning on RRSP vs TFSA account selection.
A Final Note: Be Cautious With Complexity
We all have a unique tolerance for investment complexity.
I suggest you consider the amount of work you are willing to put in for a given gain in tax efficiency. In addition, it is worth noting that greater portfolio involvement increases the risk of behavioural errors.
You can check out various model portfolios at the Canadian Portfolio Manager blog. This blog has various portfolios with differing levels of complexity. If investing were not my hobby, I’d own a single asset allocation ETF in all accounts.