How to decide on which investment account to select when investing. There are guidelines but it’s important to understand that choosing an investment account is primarily an income tax decision based on your investing horizon.
One you get past the consideration that investing is important, your next effort will be on minimizing your taxes.
While the following questions will often be asked, and the time horizon being one of the most important to start with, the amount of money you keep in the end after taxes usually prevails.
- How much money I can invest
- How long I will invest it
- Where I am at with my diversification
- Where I stand with the limits allowed for some accounts
- How I will be taxed on the investment
How to avoid paying the tax man any more money than I need to is probably at the top of my filter :). To achieve optimal tax efficiency, you must understand the tax implications of the different Investment accounts available.
I also recommend using an up-to-date tax software program, such as TurboTax Canada, to guide you until you’re ready to file.
Investment Account Income Tax Details
The following investment accounts represent the most common categorization for investment accounts with respect to the income tax rules. If you are unsure, ask the financial institution as it should fall in one of those categories for income taxes.
Taxable Account / Non-Registered Account
This is the most common account, which can range from a mutual fund account at the bank to an employee stock purchase plan (ESPP) account with your employer.
It refers to any accounts where the income and/or capital gains are taxed normally based on your marginal tax rate. All of my DRIP investments with Computershare belong to this type of account.
If you want to be technical, all your bank accounts fall in this category. If you don’t earn much interest, you never get a tax form, but if you were to earn enough interest, the bank would send you a tax form to declare your earnings.
This type of account will have multiple income tax implications depending on your investments, and the following apply:
- Dividend Tax – A specific rate calculated on your qualified dividends. It’s critical you understand the difference between a distribution and a dividend as well as the impact of holding non-Canadian dividends.
- Capital Gains Tax – When you make money from equities, there is a specific income tax rate that applies. Be aware you can offset capital gains with capital loss.
- Interest Tax – That’s treated as income so you pay your full marginal tax rate
- REIT Taxes – A combination of the above altogether. Plan wisely.
TFSA – Tax-Free Savings Account
This investment account was introduced in 2009. The TFSA has the following
- It shields investors from all taxes where all investment earnings, dividends, or capital gains are tax-free.
- You pay no income taxes on withdrawals.
- There is an annual limit for contributing to the account.
- Contribution amounts accumulate over the years, if you miss one year, it carries over.
- Withdrawals are added back to your limit for the following year.
RRSP – Registered Retirement Savings Plan
Introduced in 1957 (as per Wikipedia – I wasn’t around), the RRSP is a tax-deferred account. Not to be mistaken with a tax-free account.
It means that your income taxes are deferred until a later time. I won’t go into all the little details of the plan, but essentially, you get a tax refund on any money you add to the account and pay taxes on your withdrawal later.
While your money is in the account, your investment earnings are tax-free. You essentially get tax-free growth while your money is in the account. The goal of the RRSP account is to promote savings for retirement.
RESP – Registered Education Savings Plan
The purpose of this investment account is to promote savings for post-secondary education. Just like the RRSP, your investments grow tax-free, but you don’t get any tax refund when you add money to them.
Instead, the government contributes 20% to a maximum of $2,500 per year per child. You must have children (one or more) as the account is registered in their names.
There are many rules around adding to the account or withdrawing that must be followed. Be sure to read the rules on the Government of Canada RESP website.
Investment Account Selection Guidelines
Now that you understand the basis of the different investment accounts from a summarized income tax treatment selecting an account is a matter of being tax efficient for your investments.
For me, maximizing my TFSA takes priority over my RRSP. For some, it’s the opposite. I don’t believe there is a clear winner as everyone’s situation differs. How you plan on retiring may also have an impact on your decision.
Since I am predominantly a dividend investor, my focus is on dividend investments and my organization around tax efficiency. Aside from the accounts, you also need to understand the tax treatment on foreign investments as they don’t necessarily follow the Canadian rules.
For example, dividend income from a US corporation will withhold taxes on your dividends outside of an RRSP, which lowers the amount you get. I have also been setting up investments with Computershare to invest small amounts.
In most cases, you will want to have a discount broker and choose wisely based on your investing strategy.
1. TFSA Account
I always maximize my TFSA contribution if I can. So far, I have managed to maximize mine but not my spouse’s. So I am a little behind from a family finance point of view.
If you plan on holding US stocks, do know that 15% of the dividend will be withheld, and it cannot be claimed back. The US dividends only play a small part in the overall return on investment, and if you have a low-yield investment, 15% might not be a big deal, considering you may have a better return in the end.
2. RRSP Account
I have 2 RRSP strategies due to my employer’s defined contribution plan. I make regular contributions to my RRSP through my employer’s plan, and then I manage my self-directed RRSP with my broker.
I had a number of mutual funds in the past that I have sold to buy dividend stocks. This is the investment account where I hold the most US dividend-paying investments, as Canada has a treaty with the US for the RRSP account where taxes are not withheld on dividends. See my portfolio for details, as I hold nearly 100% in US stocks.
From a tax perspective, anything in an RRSP account grows tax-free until withdrawal time. What’s important is how you plan your withdrawal and what your income expectations are at such a time when you start thinking about taking early CPP or the implication of OAS payments.
3. Taxable Account
Just be smart about what you invest and how you trade. You can offset profits with losses in this account.