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Taxes. Ugh. Who needs ’em?
OK fine, I know I know. They’re used to pave our roads, build our schools, and pay for our sweet, sweet healthcare system, but other than that, who needs ’em?
In this country (and the US as well), working stiffs by far have the highest tax burden, since low-income families have a lower overall rate (and have government subsidies that help them), and rich people who derive their income from investments have all sorts of options to avoid paying taxes. But all hope is not lost, because when you’re working, the government does provide you with a few tools to help you legally save on taxes. For the topic of this post, I will focus on RRSPs and TFSAs, which are available to all Canadians. RESP’s will be a topic of a future post.
RRSPs stand for Registered Retirement Savings Plan and, as the name implies, is supposed to be used to save for retirement. To our American friends, this is the equivalent of your 401k/403b/457/Traditional IRA (incidentally, why the Hell did you name them so confusingly?!?)
Basically, you contribute pre-tax money directly off your paycheque and anything you invest in will grow tax-free. You can put in up to 18% of your pre-tax salary, and this will lower your taxable income, often resulting in a refund cheque when you file your taxes in April.
So how should a potential early retiree use this thing?
Well, first and foremost, max out your contribution limit! The average Canadian (and American) saves about 4% of their income (according to Stats Can and the St. Louis Federal Reserve), and that is just awful. At that rate, the average Canadian/American will experience a very painful drop in living standards when they retire and realize they have no money to live on. Maxing out your RRSP represents an 18% savings rate, which is a healthy first step in the right direction and absolutely necessary if you’re planning on retiring anytime before your 60’s.
Additionally, many employers offer some form of Defined-Contribution retirement plan that matches a percentage of your RRSP contributions. This is basically free money, yet mind-bogglingly some people don’t participate. As a finance blogger, I’m not supposed to straight up call people idiots, but if your employer has a plan like this and you’re not participating, you’re an idiot. Go talk to HR, sign the stupid forms, and get this set up right the Hell now. There’s literally no downside.
The TFSA was introduced by the Harper government in 2009, and stands for Tax Free Savings Account. For our American Friends, this is our equivalent of your Roth IRA.
Basically, you contribute after-tax money into it and any investments you make are tax-free. Because you use after-tax money, this won’t generate a tax refund, but on the other hand you can withdraw from it whenever you want and you get that withdrawal contribution room back the following year.
That last part is the most interesting and most misunderstood feature of the TFSA, and I’ll talk about that in a few paragraphs, but first, the most important thing you can do with your TFSA is again, max out the contribution room every year. It is more or less impossible to retire early if you’re not maxing out both your RRSP and your TFSA. Fortunately, if you can max out your RRSP, the government will write you a check come tax time because you’ve lowered your pre-tax income, and you can then use that to fill up your TFSA. It’s a strategy I wanted to call “double-fisting,” but I just looked that up on Google and that name has…er…other meanings.
Now, back to the withdrawal rule and why it’s so interesting. A TFSA is basically a retiree’s best friend, because anything inside of it never gets taxed or reported, and you can spend it whenever you want. So you want your TFSA room to be as big as possible. But your TFSA room can only increase by $5500 a year, so it seems the only way to get more room is just to wait for each year to roll over, right?
Nope! Say you have a TFSA with a contribution room of $10,000. You transfer $10,000 of cash into it and buy an ETF. Now, pretend that ETF rises in value by 2x, so the balance is now $20,000. How much contribution room do you have in your TFSA now? The answer is $20,000! Even if you sell that ETF and withdraw $20,000, that $20,000 withdrawal gets re-added back to your contribution room next year, so by owning something inside your TFSA that experienced a capital gain, you have permanently increased the size of your TFSA!
Let me say that again: When you experience a capital gain, you PERMANENTLY increase the size of your TFSA
Now remember, the two main asset classes are equities and bonds. Bonds will pay you a nice income, but won’t increase in value dramatically. Equities are more volatile, but over time will increase in value far greater than bonds. So by holding equities in your TFSA, you will increase the size of your TFSA over time greater than the default $5500 per year, and therefore be able to shelter more of your portfolio from taxes forever. Now, note that the opposite also holds true. If your equities go down, your contribution room also goes down. BUT as long as you index and don’t sell, over the long term your room will increase as the stock market rampages ahead.
The government named the account a “Tax-Free Savings Account” on purpose. If everyone understood and took advantage of this, the government would lose out on a lot more tax revenue than they intended to. The name itself implies you should just park cash in here rather than equities and therefore waste the best feature of the TFSA. And it worked. 80% of Canadians have their TFSA money sitting in a savings account, not realizing that they’re actually doing the least efficient thing with their TFSA, all because of that misleading name. Clever, huh?
Putting It Together
OK, so now how do we use these vehicles to make our portfolio tax-efficient? When investing, you will generally have 3 types of accounts: An RRSP, a TFSA, and a Non-Registered account (a normal Investment account). Making your portfolio tax-efficient simply means holding each asset in the right account so you pay the least amount of tax. Got it? Great.
We’re talking about ETFs that track the TSX here, mainly. Canadian Equities are equities, so you’ll want to stick them in a TFSA to take advantage of their long-term capital appreciation potential. If you run out of room, a Non-Reg is also a good place to put it since stocks listed on the TSX pay dividends that are eligible for the Canadian dividend tax credit.
These are ETFs that track the S&P500, EAFE or Emerging Markets. TFSA’s are an ideal place for these since they’re equities. After that, RRSPs (since their dividends don’t qualify for the dividend tax credit). And then after that, Non-Reg.
A special note for American equities listed on the NYSE. This is different than a TSX-listed ETF that tracks the S&P500. If it’s actually listed on the NYSE, these should never be held in a TFSA. The reason for this is that when an American stock pays a dividend to a foreign investor, the IRS withholds a 15% tax on it to cover any taxes that you may have to pay. The exception is if the stock is held in a retirement account. Unfortunately, they don’t consider the TFSA a retirement account, so you would have tax withheld by the IRS, but you can’t claim it back on your tax return since you don’t report your TFSA income on your taxes. Never hold US-listed equities in a TFSA. Hold it in an RRSP first, then Non-Reg if you run out of room.
Bonds don’t really appreciate much in value, so holding them in a TFSA is wasteful. Hold them in an RRSP instead and in a Non-Reg if you run out of room.
REITs, or Real Estate Investment Trusts, own real estate like shopping malls, apartment buildings, office buildings, etc. They collect rent from their tenants and pass it on to their shareholders. This rental income is treated like ordinary income for tax purposes, so these should be held in the same place as Bonds: RRSPs. However, unlike bonds they do have some potential for capital appreciation, so a TFSA is acceptable as a second choice. After that, Non-Reg.
Preferred shares are hybrid vehicles, midway between a stock and a bond. They trade on the stock market like regular shares, but they’re not nearly as volatile as a company’s common stock. They also pay dividends like a share rather than income like a bond, so they’re useful for getting a higher yield, plus that income is tax-efficient since it qualifies for the Canadian dividend tax credit (you can get up to 50K of dividend income tax free), so these are best held in a Non-Reg account.
OK got it? Let’s Review:
|Asset Class||Choice #1||Choice #2||Choice #3|
Let’s try an example together. Meet Mike and Amy, our imaginary investor couple who has saved up $1,000,000 in cold hard cash. They want to start investing, but in a tax-efficient way, so they decide to construct a portfolio. They’re fairly conservative, so they want to go 50% equity, 50% fixed income. After much research, they decide they want a portfolio like this:
|Canadian Equities||10% ($100k)|
|International Equities||30% ($300k)|
|US-Listed Equities||10% ($100k)|
Note: This portfolio is for illustrative purposes only. In no way am I recommending this allocation for your personal situation.
Mike & Amy have accumulated a whole bunch of RRSP room while they were working, as well as some TFSA room but never bothered opening any accounts. Fortunately, all that room carries forward indefinitely so they go to a brokerage firm and open up accounts, filling them up with all the cash they’ve saved. Here’s what their initial accounts look like:
So the challenge is, which assets go into which buckets?
We do this by going over each account type and figuring out which assets really REALLY want to live there. Similar to draft picks in the NBA, we want everyone to get their #1 choice first before we move on to the #2 choices.
Let’s start with the TFSA. We know that equities should go in there (but NOT US-listed ones), so let’s start with the Canadian and International Equities. Both are way too big to jam in the TFSA, so we’ll have to do our best. Rather than fill the TFSA up with all Canadian or all International, let’s have both in there, so we buy $50k each in the TFSA. The TFSA is now full. Mike’s accounts now look like this:
Now let’s move on to the RRSP. Bonds and REITs really want to live there, and fortunately we have enough room, so let’s go ahead and jam them in. Also, US-listed equities. We don’t have enough room for all US-listed equities, so we’ll buy as much as we can.
And finally, Non-Reg. Preferreds want to go there, so let them!
At this point, we’ve used up all the room in our tax-sheltered accounts, so we’ll just buy the remaining in Non-Reg.
We have now constructed a portfolio that is pretty tax efficient. The RRSP is sheltering all our income-producing assets, the TFSA is holding our equities, and the Non-Reg is holding stuff that either churns out tax-efficient dividends (preferreds) or is expected to appreciate in value, generating capital gains (equities).
As of course as time goes on and Mike & Amy generate more contribution room in their RRSP or TFSA, we will want to redo this analysis and move stuff around accordingly. Generally, as their TFSA grows (the two of them will be generating $11000 of room each year), we want to move more and more International equities in there. Eventually, they will reach a point where they have enough room in all their accounts that every asset can go to its #1 choice, at which point they will essentially never have to pay taxes ever again.
So that what making your portfolio tax-efficient means. Just holding the right assets in the right accounts. No rocket scientists needed.
Questions? Concerns? Let’s hear it in the comments!