A reader asked a very good question as to how I decide 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.
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 need to understand the tax implication of the different Investment accounts available. I also recommend that you use an up-to-date tax software program, such as TurboTax Canada, to give you step-by-step guidance 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 not sure, 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 when the income and/or capital gains are taxed normally based on your marginal tax rate. All of my DRIP investments with CIBC Mellon and 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 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 accounts 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.
- 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 at a later time. While your money is in the account, your investment earnings are all 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
This 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 it. Instead, the government contributes 20% to a maximum of $2,500 per year per children. You must have children (one or more) as the account is registered in their names.
There are many rules around adding to the account or withdrawing that must be followed. Be sure to read up on the rules on the Government of Canada RESP website.
Investment Account Selection Guidelines
Now that you understand the basis of the different investment accounts from a summarized income tax treatment, selecting an account is a matter of being tax efficient for your investments. For me, maximizing my TFSA takes priority over my RRSP. For some, it’s the opposite. I don’t believe there is a clear winner as everyone’s situation is different. How you plan on retiring may also have an impact on your decision.
Since I am predominantly a dividend investor, my focus is around dividend investments and my organization around the tax efficiency. Aside from the accounts, you also need to understand the tax treatment on foreign investments as they don’t necessarily follow the Canadian rules. For example, dividend income from US corporation will withhold taxes on your dividends outside of an RRSP which lowers the amount you get. I have also been setting up investments with Computershare to invest small amounts.
In most cases, you will want to have a discount broker, choose wisely based on your investing strategy.
1. Computershare Account
I have highlighted the benefits of having investments with the transfer agents as it allows you to:
- Start with only 1 share and a very low fee of 10$
- Add small amounts to your investments regularly
- Benefit from the fractional shares
- Benefit from the dividend re-investment discount
My filter for those investments as you can see in my monthly dividend report is around companies that provide a necessary service such as banks, utilities and telecoms (not a necessary service but we just can’t live without them). I get companies that I feel I can invest in without monitoring the price and simply letting them average out over the years. Aside from REIT, they all generate dividends that are taxed efficiently in a non-taxable account.
2. TFSA Account
I always maximize my TFSA contribution if I can. So far I have managed to maximized mine but not my spouse. 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.
3. RRSP Account
I have 2 RRSP strategies due to my employer’s defined contribution plan. I do regular contribution 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 investments. This is the investment account where I hold the most US dividend paying investments as we have a treaty with the US for the RRSP account where taxes are not withheld on dividends. 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 time.
4. RESP Investments
I started with mutual funds and I am still with mutual funds. Due to the small amounts added monthly, mutual funds is what made sense from a fee perspective. You could have the ability to put in a lump sump and buy stocks if you want. It really depends on your budget. I don’t plan on making changes to it.
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