Canadians have access to several investment accounts, and each provide their own advantages. The two most popular are the Tax-Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP).
The key to maximizing your returns is to use each account in the most tax-efficient way. The feds aren’t in the habit of minimizing your taxes, so when there are tools at your disposal to do so, it is important to take advantage.
Contribution limits
The TFSA is a relatively new investment vehicle, and the contribution limits are straightforward. In 2019, the maximum contribution limit jumped to $6,000, up from $5,500 previously. Any unused contribution room under the cap can be carried forward to the previous years. In other words, if you haven’t contributed and have been eligible to do so since inception (2009), then you would currently have $63,500 in contribution room.
Similar to the TFSA, any leftover contribution room in your RRSP is carried over to the following year. The difference, however, is that contribution room is determined by a percentage of your net income up to a maximum amount. In 2019, that is 18% of your net income up to a maximum of $26,500.
Types of investments
This is where investors make mistakes. Generally, these accounts can hold similar investment types. Bonds, GICs, individual stocks, exchange-traded funds and mutual funds are among the most common investment types. What to hold and where is all dependent on taxes. Any domestic investment product is generally treated equally, and there are no differing tax implications.
Where it makes a difference is when you are purchasing foreign investments. Canada and the U.S. have a long-standing tax treaty whereby withholding takes are waived if investors hold U.S.-listed stocks directly in a RRSP. Unfortunately, this is not the case for U.S. equities held in a TFSA and is a common misconception. If you hold dividend-paying U.S. stocks in your TFSA, they are subject to a 15% withholding tax. This is also true of some dual-listed stocks.
Case in point, consider the Brookfield family of companies. Let’s use Brookfield Property Partners (TSX:BPY.UN)(NYSE:BPY) as an example. An investor who owned 1,000 shares of BPY.UN would received $1,740 in annual dividends. If the stock is held in an RRSP, the investor would receive the full amount. However, Brookfield Property Partners’s dividends are considered U.S. distribution and are thus not exempt from the withholding tax. As such, those who hold BPY.UN in their TFSA would only receive $1,479 in annual dividends.
These are important factors to take into consideration. Although it may possible to recoup the withholding tax, it is a complex tax endeavour and quite the hassle. It is why experts suggest that U.S. dividend-paying investments be held in an RRSP.
When to make use of these accounts
If you are saving for a trip or planning to make a large purchase, then the TFSA is your best option. As long as investors respect the contribution room, they can freely move money in and out without tax implications. Does this mean that saving for retirement is best done within an RRSP? Not necessarily.
It is important to note that RRSPs are tax-deferred accounts. This means that you will be taxed on your withdrawals come retirement. Given this, if you are in your early and low-income earning years, it is recommended to first max out your TFSA. If you are at the top end of your income earning and expect to make less income in retirement, then contributing to your RRSP is a good choice. This way, you will pay less overall tax on your income earned, as you will have a lower tax rate in retirement.
If you have the means, a combination of both is the best option. The TFSA is one of the most underutilized investment vehicles. The ability to grow your investments tax-free with no tax implications upon withdrawals is a benefit that most underappreciate.
