When it comes to tax free investing many people I know will directly point to two popular methods to do it. The RRSP and the TFSA account. These are two of the most popular investment tools available to Canadians today. They both enjoy prime media coverage and the benefits of each are well known and written about here on this blog.
Unlike many people I know, I also take advantage of non-registered brokerage accounts to do my investing. You might be wondering what non-registered accounts are. They are simply brokerage accounts that allow buying of stocks, bonds, mutual funds and a plethora of other investment types that are available in public exchanges. The difference with non-registered accounts and one like the TFSA and RRSP is that gains and losses must be recorded and taxed accordingly by the CRA. The tax shelter abilities of the TFSA and RRSP don’t apply to non-registered accounts.
Having A Long Term View
You may wonder why anyone would use non-registered accounts to invest when the majority of people can’t fill their TFSA accounts nor their RRSP accounts. Well for starters the TFSA has a restriction on the amount that can be contributed on any given year. If you can save and make the maximum payments towards a TFSA account, then the RRSP is the only other alternative for tax free investing.
I’ve written much about how RRSP accounts work and why it’s a tax deferral strategy and not necessarily a tax free strategy. An article presented by John Heinzl at the Globe and Mail suggests that the RRSP receives a lot of flak and why the RRSP should be used rather than a non-registered account. There are a lot of assumptions that are made in the above article including the notion of making an RRSP contribution at the pre-tax amount rather than after tax amount. This gross up manoeuvre is what makes his argument very intriguing to a long term investor because that extra amount actually makes a big difference.
For myself, I decided to take a different approach to investing. Rather than topping up an RRSP account, I decided to use a non-registered investment account instead, but before I get into my strategy let’s review why I did this versus using an RRSP account.
- I have a long term view on my investments. Long term meaning somewhere in the realm of 15-25 years. I do not plan on selling my investments prior to that time frame.
- I rarely sell my investments. I rebalance by adding money to my portfolio rather than selling existing equities.
- I’m nowhere near the top end of the marginal tax brackets. I plan on replacing my income when I retire in full, similar to a defined pension through contributions to my investments. I do imagine that my future marginal tax rate will be equal to or even higher than my current one (taxes never really go down, do they?).
- My TFSA contribution room is already full, so there is no other alternative means to avoiding taxes.
- I’m still making the assumptions that any money in an RRSP will be forced to be removed into a RRIF at some point with minimum withdrawal requirements.
There is a fundamental difference between money made through a non-registered account and an RRSP account. When an equity that is purchased in a non-registered goes up in value and sold, the gain is taxed as capital gains. Only half of the value of capital gains are taxed at the marginal tax rate. Not the full capital gains.
If I collect any interest income in my non-registered account through investments such as GICs or bonds, then that full amount is taxable at my marginal rate. These types of investments although very risk adverse, are really bad for taxes in non-registered accounts.
Dividends are also taxed, but not fully. If dividend income is received from Canadian corporations, individuals are given a tax credit by the CRA that allow the investor to pay less tax. This happens because dividends have already been taxed by the CRA.
There is no distinction between capital gains, dividend or interest in an RRSP. All withdrawals from RRSPs are taxed at the marginal rate because it’s considered earned income. So whenever I take money out of my RRSP, the full dollar amount will be fully taxed at the marginal rate.
Deferring Taxes Using RRSP
The strategy I use may be a bit different than how many individuals may use their RRSP accounts. I prefer to use the RRSP account solely for the purpose of tax deferral. Rather than making contributions to my RRSP to the maximum that I can afford per year, I prefer to keep my investments in a non-registered account. There are a few reasons why I choose to do this:
- I expect myself to move to a higher tax bracket in the future before retirement. Leaving room in the RRSP means I could potentially take advantage of the tax deferral strategy to a greater extent, though highly unlikely.
- The money is a bit more liquid in a non-registered account. I don’t have to fear taking out money from an RRSP account and risk going into a higher marginal tax bracket while I’m still working.
- I can avoid potential government claw backs against OAS and GIS if these are even still available when I retire.
- I will have more control over my earned income in my retirement years as opposed to being required by the government to withdraw my RRSP funds.
- Allows for the ability to do tax loss harvesting if it is at all applicable.
Every year, my investments will rise or fall. If I so choose to exercise any capital gains, collect dividends or gain interest income then I would incur taxes on those gains. Rather than paying those taxes, I choose to make an RRSP contribution equal to or exceeding the amount that I have to pay tax on. In essence I’m deferring when I pay taxes to a later date.
Using this strategy, I have never had to pay any capital gains or interest tax while investing using my non-registered account. At the same time, most of my investments can sit outside of my RRSP account and potentially gives me more financial flexibility. For example, if I sold equities that had gains, I would only count half of that gain against my current income and only pay taxes on that half. Taking money out of my RRSP would mean that I would have to pay taxes on the full amount. Not only that, the entire amount would be considered earned income, and the potential may exist such that the income would push me into a higher tax bracket. Pushing into a higher tax bracket would definitely make the investment in the RRSP a bigger loser.
Even using this strategy, I continue to invest the RRSP contributions as if they are a part of my balanced portfolio, but potentially using it for income streams that incur greater taxation.
It’s impossible to determine whether my strategy will actually work out better or worse than putting all my investments in an RRSP account. That is because the future is hard to predict. What will the tax rate be? Will there be changes to the taxes on capital gains? What if the withdrawal requirements for RRSPs are removed?
These are all great questions. Deciding on doing one way or another is a tough decision, but one thing is still certain. It’s still important to invest for your future no matter what you are doing. I chose to invest this way because it seemed to work for me and it seemed like the right thing to do to match my personal financial goals. Perhaps this method doesn’t work for you, but the one thing that remains is that you should stay invested regardless of what methodology you use.