Registered Retirement Savings Plans, or RRSPs, help you to save for a more comfortable retirement while deferring taxes – hopefully on more favorable terms – into the future.
But the investment tax planning process has been complicated somewhat in recent years with the introduction of the Tax-Free Savings Account, or TFSA.
Now that you have two registered savings plans you can invest in, a number of questions come to mind: For example, how should you arrange your assets inside and outside these plans? Or if you have limited funds to invest, should you give priority to one savings plan over the other?
Know your objectives
The answer to these questions, of course, will depend largely on your investment objectives and goals.
Indeed, you may have different goals for the money you want to set aside for saving and investing purposes.
If you’re saving for a car and your retirement at the same time, for example, you’ll probably find it best to use the TFSA for the short-term objective of saving for your car, while using your RRSP for your retirement savings contributions.
If, you’re using both your TFSA and RRSP for retirement savings, however, the savings plan you give priority to should generally depend on your expected marginal tax rate after you retire.
If you expect your marginal rate to be lower in retirement than it is now, give priority to your RRSP. On the other hand, if you expect your rate to be higher in retirement, a TFSA contribution now is your best bet.
Another thing to keep in mind when arranging your retirement investments inside and outside your registered plans is to treat them as a single portfolio.
Begin by balancing the investments in your portfolio among the main asset classes: cash; fixed-income investments such as bonds and GICs; and equities, be they foreign or domestic, higher-risk or lower-risk, and so on. Your asset mix, of course, will depend in large part on how soon you need cash from your investment portfolio.
In general, the longer your time frame, the greater risk you can take. But your asset mix will also reflect other factors, such as your financial and personal circumstance, investment knowledge and risk tolerance.
Once you’re happy with your asset mix, it’s time to address the question of what securities work best in your registered savings plans and what ones don’t.
To the extent that you don’t need interest income to immediately live on, you should give priority to holding interest-paying investments – fixed-income securities and cash – inside your savings plans (RRSP or TFSA).
That’s because interest income, unlike dividends and capital gains, enjoys no special tax advantage. Interest-paying securities, therefore, work hardest for you when they’re sheltered and their interest can compound free of tax.
You could, of course, consider keeping your emergency cash reserves in your TFSA, where it can be withdrawn without withholding penalties or tax consequences.
But given today’s extremely low interest rates on cash balances, you’re probably better off giving priority to other investments in your savings plans.
When it comes to allocating equities inside and outside your plans, some financial advisers state flatly you should never put stocks (or stock funds) in your RRSP.
That’s because gains from Canadian stocks and the funds that hold them come mostly in the form of dividends or capital gains, both of which offer income-tax advantages if held outside a registered plan.
If you receive gains in these forms inside your RRSP, you’ll ultimately pay tax on them, when you withdraw money from your plan, at your full rate with no advantage.
Equities and your RRSP
If you can fit your entire retirement investment portfolio inside a registered plan, however, there is a case to be made for holding equities inside your RRSP.
After all, stocks tend to outperform fixed-income securities over the long term. Including equities in your RRSP, then, gives it stronger growth potential to fund your lifestyle in retirement.
Then too, given that RRSP contributions are tax deductible, the more you contribute to your RRSP now – even if it includes stocks – the more you can lower your tax in the near term.
But the TFSA can be an even more attractive place than an RRSP to put your equities. That’s because, though TFSA contributions are not tax deductible, withdrawals from these plans are tax exempt.
The dividends and capital gains you make on equities in a TFSA, therefore, are not taxed at all. That’s an even better deal than holding your equities in a non-registered account, where even though you’re taxed on dividends and capital gains, you at least receive favorable tax treatment.
So, putting aside considerations of marginal tax rates, a TFSA is generally your best choice for buying equities if you want to maximize your after-tax returns. Give priority to equities in your TFSA, then, unless the tax deductibility of an RRSP contribution is more important to you.
In applying the above discussion to mutual funds, you’ll generally want to hold any fixed income or bonds funds you own inside an RRSP or TFSA if you don’t need the income from these funds to live on in the immediate term.
Since the interest income from bond funds enjoys no special tax advantage, these investments will generally work best for you where they can compound tax free.
Equity funds that report mostly capital gains should receive priority in your TFSA, followed by a non-registered account.
Consider placing Canadian dividend funds, such as PH&N Dividend Income, outside your registered plans, where you can make use of the dividend tax credit.
But place foreign dividend funds, such Franklin U.S. Rising Dividends, inside a registered plan, since dividends from these funds receive no special tax treatment.
In the end, deciding what investments to put inside and outside your registered savings plans, and what to put in your RRSP versus the TFSA, depends on a number of factors, such as your investment objectives and financial circumstances.
But when making your allocation decisions, think of them in terms of what is the best way to maximize your after-tax returns.
The TaxLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846