- 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 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.
Account Tax Treatment
The following accounts represent the most common categorization for investment accounts.
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. 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 earning.
TFSA – Tax Free Savings Account
This account is fairly new for Canadians. Three years ago, we had the honor of having the ability to invest $5,000 per year in a TFSA where all investment earnings, dividends, or capital gains is tax free. I won’t go into the details of the TFSA. If you want the details, the Canadian government has setup a site dedicated to it. The two main points are:
- You can only add up to $5,000 to the account per year
- All earnings are tax free
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 taxes are deferred to 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. 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 RRSP account deserves a post on its own but that’s not for today. You’ll have to satisfy yourself with Wikipedia or the Canada Revenue Agency details. The goal of the RRSP account is to promote savings for retirement.
RESP – Registered Education Savings Plan
This purpose of this account is to promote savings for post-secondary education. Just like the RRSP, your investment 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 $2,500 per year per children. You must have children (one or more) as the account is registered in their names and you have an age limit.
There are many rules around adding to the account or withdrawing that I won’t cover them here. Instead, I’ll highlight a RESP book from a fellow blogger: “The RESP Book: The Complete Guide to Registered Education Savings Plans for Canadians“
If you are hungry for some government literature, they have some RESP legalese for you.
Account Selection Guidelines
Now that you understand the basic of the different accounts from a summarized tax treatment, selecting an account is a matter of being tax efficient for your investments. For me, maximizing my TFSA takes priority over my RRSP. For some, it’s the opposite. I don’t believe there is a clear winner as everyone’s situation is different. How you plan on retiring may also have an impact on your decision.
Since I am predominantly a dividend investor, my focus for this post is around dividend investments and my organization around the tax efficiency. Aside from the accounts, you also need to understand the tax treatment on foreign investments as they don’t necessarily follow the Canadian rules. For example, dividend income from US corporation will withhold taxes on your dividends which lowers the amount you get. I have also been setting up investments with CIBC Mellon and Computershare as you have seen from my Dividend Income reports.
1. Transfer Agents Setup
I have highlighted the benefits of having investments with the transfer agents as it allows you to:
- Start with only 1 share and a very low fee of 10$
- 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 Maximization
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. I do not buy US dividend companies in this account as I cannot maximize the dividend re-investment capabilities due to the tax withheld. DRIP is important for compound growth.
3. RRSP Optimization
I have 2 RRSP strategies due to my employer’s define 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 account where I hold my 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 a RRSP account grows tax free until withdrawal time. What’s important is how you plan your withdrawal and what your income expectation 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 with it.
Readers: What is your filter order for deciding on where to put your money?