In the last episode, we discussed different investments that you can buy. Like stocks, bonds, or funds that bundle those together. You hold those investment products inside containers called accounts. This week, we start exploring the different investment accounts that you can use to hold those investments in. We will home in on an alphabet soup of special accounts available to Canadians. The registered accounts, like RRSPs, RDSPs, TFSAs, RESPs, and FHSAs all have specific rules to be aware of. It is definitely worth your while because they also come with tax benefits and sometimes even government grants. With some potential for claw backs if you aren’t careful. Like free kittens. Join us for this episode to make sure that you keep your portfolio purring.
[00:00:02] BF: Welcome to the Money Scope podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital. And Dr. Mark Soth, aka The Loonie Doctor.
[0:00:17] MS: Welcome back. In our last episode, we went very deep, hopefully not too deep. But we went very deep into the basics of managing a portfolio. That was definitely our longest episode. So we hope that it wasn’t too much to digest. We covered territory like asset allocation, how risks are combined together in a portfolio, how your portfolio interacts with other parts of your life, like your human capital, and how to choose your asset allocation while trying to consider your behavior in down markets, and balancing that to try to get the best return in your investments.
So we also covered a lot of the practical aspects of portfolio management as well, that scare people like rebalancing. It’s not an exact science. Portfolio management, there is no perfect portfolio. However, with all the information that we’ve got, we can actually make pretty good portfolio, so that’s going to be good enough for us.
[0:01:06] BF: Definitely. Good enough for most people. It’s funny, good enough for even big institutions who often try and make things complicated than they need to.
[0:01:12] MS: Yep.
[0:01:13] BF: In all this stuff, it’s important to keep the portfolio pyramid in mind, that the base of the pyramid is just getting invested. A lot of people don’t invest at all, and that’s where you’re giving up the biggest benefit, is by missing out on returns. The next in the pyramid is minimizing the behaviour gap. That idea mingles with the cost of paying for financial advice and paying for advice may reduce your behaviour gap. Then, at the tip of the pyramid, and the smallest expected benefit is tax optimization.
Today’s episode, we’re going to start unraveling the mysteries of the tip of the pyramid, by detailing the account types that are available to Canadian investors. These accounts are where we hold our investments, then we got different tax treatment and attributes. Tax is foundational information that all investors need to know, but it’s complex. So we’re starting with account types today. We’re going to break tax with respect to investing up into several episodes though.
[0:02:05] MS: Yes, that’s right. Taxes and investing are complicated and it’s really hard to get a clear view of that. It’s like how the small intestines are for humans. And similar there, we’re going to break this into three main sections. This episode, we’re going to discuss the basics of the types of accounts available to Canadians. Then in our next episode, we’re going to go on a little deeper, discuss how investment income is distributed and taxed. That’s a topic that’s most relevant to investing in taxable accounts. We’re going to talk about taxable accounts in the next episode. It does have implications for other accounts as well, so we’re going to be mixing that in there.
Then, we’ll explore some opportunities after that to optimize some of our tax treatment in our portfolio. That last part is like the terminal [inaudible 0:02:46] it’s complex. Really, does anybody shine a light directly into there? But we’re going to do that.
[0:02:52] BF: That was so good. The three sections to the small intestines?
[0:02:55] MS: That’s right, yes.
[0:02:56] BF: Yes, that’s hilarious. That’s just too good.
[0:02:59] MS: And it’s one of those parts you just can’t get a good look at either.
[0:03:02] BF: So good. All right. So we are ready to insert the money scope. Hopefully, you’ve digested the last episode, because we’ve got the push and terrascope lined up this time. It’s going to take a few episodes to get through this taxing topic. But we aren’t going to quit until we see the light at the other end.
[0:03:17] MS: That’s right, literally.
[0:03:21] MS: Great. So, we’re going to start off with talking a little bit about some of the big terminology that we use when we have different investment accounts. One of the big break-ups of that information is registered versus non-registered accounts. So, in Canada, we’ve got multiple different accounts that we can use.
These again are like the bags that we can hold our investments in. We can use that structure both to help us keep track mentally of where some of the money is and what we’re planning to use it for. But also, each of those accounts may have their own rules and tax characteristics.
With some of the common goals and circumstances, the federal government actually permitted a variety of special accounts. These special accounts are commonly referred to as registered accounts because they’re registered with the government. This would include accounts like RRSP, or TSFA, FSHA, the RESP, and the RDSP. Those are probably the biggest ones that we are going to spend some time on, but there’s also LIRAs, and RRIFs, and LIFs.
We’re going to describe what all of those different letters stand for as we unpack each of them individually. So don’t let that intimidate you. It’s actually pretty reasonable once we start to break it down. So those registered accounts all have some form of tax sheltering, and/or tax deferral.
To avoid them being used by wealthy people, to prevent just from sheltering a bunch of income from tax that means they actually have some limits to how much we can contribute to them. Even though you have more money, you can’t just keep putting more, more money into these tax shelters. There’re limits because of that.
Once that limited room that’s available to you is full, that’s when you would be considering using some of those other account types that we commonly refer to as non-registered accounts. Or sometimes you’ll hear them call it taxable accounts, because they’re tax exposed.
So those non-registered taxable accounts, you have to pay taxes on those, on whatever the income is within those account setting. Who owns and pays the taxes on those accounts is important, and that could also be used to describe them as well.
For example, I may have a personal taxable account that I own, or we may have a joint account with my spouse, my corporation might have its own corporate account. That corporate account is simply a tax-exposed account that’s owned by the corporation and the corporation pays taxes on it. So those are the two big groupings of account types that we’ve got.
[0:05:34] BF: I just want to add a couple of other terms that get thrown around when we start talking about taxable accounts, you might hear about cash accounts, you might hear about margin accounts. Those are just different names for taxable investment accounts. You don’t just have to hold cash in a cash account for example.
A margin account just means that the brokerage that you’ve opened the account with will lend you money to buy investments in the account. On a margin loan, you have to pay interest, you’re also exposed to the risk of something called a margin call, or you have to pay down the loan, or add more collateral to the account. Okay, so that’s it. But margin and cash account are just other ways to describe a taxable account.
With that high-level terminology out of the way, we’ve got registered accounts, we’ve got taxable accounts, let’s start diving into the individual account types. We’re going to start with the registered accounts, because they have those unique tax attributes by account and different uses and stuff like that, so there’s quite a bit of detail. They’re also where most people should start their investing. The taxable accounts don’t have special tax attributes themselves, they’re just – I mean, they don’t have any real special features. But describing taxes on taxable investments in a taxable account is itself a big job. So, we’ve set that aside as a completely separate episode.
Before we get into the details of the account types, I do want to reiterate what Mark mentioned earlier, that these accounts are like the bags that we fill with investments, different financial institutions are going to offer you different products in those bags. If you open an RRSP at one bank, you might be able to access different products, then you would be able to access at a discount brokerage, for example, but that’s the difference. The actual accounts are the same, the overall structure is the same. What differs is the products that the institution that you open it with is willing to sell you.
[0:07:08] MS: That’s right. That’s a really big important point. Because no big surprise if you open an account with a bank, and it’s not a self-directed account, where you get to choose everything. They’re going to usually want to fill that with their proprietary mutual funds. And that’s important because those are also the funds that often have some higher costs associated with them, and they can be difficult or unable to be transferred to other institutions because they’re proprietary. That means you’d have to sell them first to switch to a different institution.
So, when you open an account, make sure that it can hold the investment products that you want it to hold, and not just what they want to put into it. That means understanding what the products options are, like the lower fee TFs, or mutual funds that we discussed in some of those previous episodes.
[0:07:47] BF: Yes, it could go in the other direction too. If you open an RRSP account, I don’t know if this is accurate or not. But if you open it at, say, a credit union, you may only be able to access GICs, or cash, and not any long-term investments. So, it really does matter. You have to make sure that you can access the type of products that you want before you open the account, and definitely, before you fund the account.
[0:08:07] MS: Yes. I know that my parents had a mutual-fund-only RRSP at their bank for a while there, and it can only hold their mutual funds.
[0:08:15] BF: Yep, exactly makes sense. They call it a mutual fund RRSP, so people think that there’s such thing as a mutual fund RRSP, but that’s a product, that’s not an account type.
[0:08:23] MS: Exactly.
[0:08:24] BF: Now, it’s also worth mentioning that when we talk about the contribution room for these account types, which we’re going to get into in a minute, that room is a combination of all of your accounts of that type. So if you have five different TFSA accounts at different institutions, you can only contribute up to your personal global contribution limit across all of those accounts combined. It’s not an amount of room per account.
[0:08:46] MS: Yes. I think one important point with that is, if you start opening a whole bunch of accounts, it becomes very hard to track where your money is, and what your contribution limits are. So simplicity, again, is really, really important when you’re deciding how to have your accounts managed.
So we’re going to start off with the Tax-Free Savings Account. You’ll hear, here called the TFSA. It’s actually a relatively new account type that came out. It came out back in 2009, but it’s very, very powerful. One of the key characteristics of a TFSA, is that it’s an after-tax account. When we say after tax, it means that your after-tax dollars go into the account. So, you’ve taken some income of some type, you pay tax on it, you can put what’s left over and invest in a TFSA.
Now, the unfortunate thing about the TFSA name is it can actually mislead a lot of people from its most powerful usage. It says savings account in the name, but its most potent usage is really actually as a long-term tax-free investment account. You don’t have to open a TFSA at a bank, or credit union, and fill it with whatever savings products that just earn interest. You can actually open a self-directed TFSA at a discount brokerage or whatever brokerage your advisors using and invest it in the same long-term investments that you would use otherwise. So, it’s not just for saving and earning interest.
The other reason why we started with TFSA is because it does have a couple of drawbacks, which may actually be advantages when you’re just starting out. So one is that you must invest after-tax personal dollars. Earlier on in your career, you may not have as much income, and it’s more lightly taxed than it will be later on.
The other big limitation is that it’s got a very small amount of room relative to the other accounts that you’re able to access. That may not be such a big disadvantage when you’re starting out, because that’s also a time when it tends to be the hardest to find enough money even just to invest in a small account type and fill it up. Those are two reasons why I think the TFSA is one of those ones that are one of the first accounts that I would think about.
Now, on the other end from the contribution is taking the money out. The good news is that, with a TFSA, because it’s after-tax money that you’ve put in there, and it’s growing tax-free, there’s no risk to withdrawing that money out at a higher tax rate in the future, and having to pay taxes at that point, it comes out tax-free. That’s one of the benefits.
The other benefit is that when you put money into a TFSA, if you were to gift money to a lower-income spouse or a child, because you wanted them to invest it, and then take advantage of their low tax rates relative to you, there’s something called the attribution rules that can kick in that don’t allow you to do that without it being attributed back to you, and taxed at your higher rates. But one of the benefits of a TFSA is that those rules about gifting money don’t apply. So, the attributions just simply don’t apply to a TFSA.
So, a parent or spouse could contribute to their low-income loved ones TFSA. Now, the money becomes theirs legally. So that has to be acceptable to you that you’ve given that money, and it’s their money now. But by doing that, you can reduce your overall household tax bill because it’s going to grow and come out in their hands over time, so you can take advantage of that.
[0:11:48] BF: I’ve got more to say about attribution. But I also want to mention just on the TFSA’s benefit of paying the tax now and therefore not having to pay it in the future. There’s an academic paper that looked at this for American investors, looking at their equivalents to these types of accounts. I don’t remember the specific details, but they found that even for someone who’s got a high tax rate, now it’s optimal to have some amount contributed to the tax-free account because that account is risk-free relative to future tax rates, because we’ll get into this more when we get to the RRSP. But there’s some risk of ending up a little bit worse off by having a higher tax rate in the future, but the TFSA hedges that risk. Like you said Mark, because you use after-tax dollars to make a contribution, that can be viewed as a downside, but it can also be viewed as a hedge against uncertain future tax rates.
Okay, so on attribution, I think that the TFSA does get really interesting with kids, for sure spouses too, if you have a lower income spouse, but also with kids. When a child turns 18, they start to get TFSA room, they start to accrue TFSA room. So as a parent, you can start filling up your kids’ TFSA as soon as the room becomes available. The benefit of doing that early as soon as the room becomes available is that TFSA room grows as the investments inside of it grow, and I’ll explain what that means.
The government decides how much new TFSA contribution room is allowed for everybody. So, everyone gets the same amount of new room every year. In 2023, it was $6,500.
Now, what’s interesting with respect to the room that I was just talking about is that if you contribute $6,500 to your TFSA, and it then grows to $8,000, your room, your TFSA room is now $8,000. Someone born before 1991 who has never contributed to their TFSA would have $88,000 of contribution room in 2023. That’s the total amount that can be available, forgetting about any investment growth.
Now, people who’ve been maxing their TFSA out since 2009, they’re typically going to have accounts worth a lot more than $88,000. Because they’ve been growing their investments over that full period of time. From 2009 to 2023, investment returns have, at least the market have generally been pretty positive. So, if you’ve been maxing it out and investing in stocks, for example, the amount in your TFSA is going to be a lot bigger than the total available room for somebody who’s never made a contribution.
If you don’t know how much room you have, you can get that from your Notice of Assessment or from your CRA online account. But it’s very important to note that you are ultimately responsible for knowing how much room you have, not CRA.
I’ve seen this with new immigrants to Canada where for whatever reason, their CRA accounts showed that they had room as if they’d been in Canada much longer. But they in fact did not have that room and they ended up getting in trouble with an overcontribution and series like, “Well, it’s not our fault. It’s not our fault we made a mistake.”
[0:14:26] MS: Yes. Exactly.
[0:14:28] BF: That’s just worth being aware of. Now, unlike some of the other accounts that we’re going to talk about in a minute, you can actually withdraw money from the TFSA. But that’s pretty interesting feature. When you take money out, you get the amount of your withdrawal back in the following calendar year, plus whatever new room is available.
As an illustration, if you have that $8,000 that I mentioned, you had $6,500 room, you contribute the $6,500, it grows to $8,000. If you withdraw that, the next year, you’re going to have $8,000 of room based on your previous year’s withdrawal plus whatever the new room is. That’s just an illustration of the fact that you really are getting additional room as your account grows. That ability to withdraw makes the TFSA really, really flexible in terms of how it can be used.
[0:15:10] MS: Yes, and it’s very, very important to not put that money that you take out of a TFSA back in the same calendar year, because it takes to the next calendar year for that extra room to be back available again. So, you don’t get that back until the next following year. And you might be okay if you have a lot of unused TFSA room, and you take some money out, then put some money back in. But that money is going to be taking from your other RRSP contribution room that you’ve got. If you have your TFSA maxed out, then you take money out and prematurely put that money back in before the next calendar year, that would be an overcontribution. The penalties for overcontribution are quite huge, 1% per month penalty. That’s a big penalty.
That’s also the second reason I think why the TFSA name is a bit misleading. You should not be using your TFSA as some sort of short-term account, where you’re constantly flowing money in and out of it, because you’re going to end up going over your contribution room and having to pay those penalties.
Now, it could be used to save for more intermediate-term plan spend. So, you’re not just taking money in and out, but you’re putting in there, saving it, and you’re going to spend it on something specific. Or you could use some stable liquid saving instruments in a TFSA as an emergency fund, and hope that you don’t need to touch it. But it’s not something you want to be moving money in and out frequently.
I’d also say, that if you were going to be using it for those types of interest-paying lower return type of saving products, I’d only really consider doing that if I did not have the financial stability enough that I could max up the TFSA with more growth-oriented long-term investments.
So, if the only money that I have and I need as my emergency fund, then saving it in a TFSA could make sense. But ideally, the TFSA would be used for more long-term investments. If you have enough room in there, and you don’t have enough money to invest in everything, or save and everything, but you have enough room, you could have some savings and some investment type of products in there as well.
So, let’s say, I had $88,000 of TFSA room, I’ve got $20,000 available to invest, but I also need to have $10,000 of reliably their savings type of money. I could put both those into my TFSA and just hold some investment products for my investing and then some savings-type products for my savings, because that would all fit within my limit.
[0:17:27] BF: I think it’s worth mentioning too, that you’ve got your limit. Remember what we said earlier, your limit applies to all of your accounts. But you’re also not limited to the number of accounts that you can have. So, you could have a TFSA at your bank where you keep a savings account, and a separate TFSA at your brokerage where you keep your investments. So, you’ve got to stay within your limit, but you can – to make it even easier, to think about, you can have separate accounts for separate uses of funds, all within your global TFSA limit.
[0:17:54] MS: Yes, just keep track of the contribution.
[0:17:57] BF: Definitely, yes. It’s like you said earlier, you don’t want to be doing a lot of transactions with this account. Because you can – I mean, in a hypothetical scenario, you could go over your contribution limit while having $10 in your account if you keep contributing and withdrawing throughout the year.
Now, you can open a TFSA at most financial institutions. So, the institution or even the part of the institution that you’re dealing with is going to determine what’s available to purchase inside of the account. You can hold most common investments like cash, GICs, bonds, stocks, and ETFs, mutual funds inside of a TFSA. Ideally, like you mentioned, Mark, the TFSA is ideally used for long-term diversified investments with a positive expected return. I’ll explain why that’s important, and I think it is really important.
People, for some reason often seem to want to do their speculative trading. Actually, from your story have some insight into maybe why this is, but we’ll get there in a second. But I’ve noticed this, people want to trade in their TFSA. If they think that some stock is going to do well, or if they want to make a bet on something, they want to do it in their TFSA. Now, the problem with speculating in your TFSA is that that’s actually riskier than speculating in your taxable investment account for a couple of reasons. When you speculate in a taxable account, the government, and we’ll talk more about this in the next episode about taxable investing. The government shares in your gains and losses. In your TFSA, it’s true that your gains are tax-free. So, if you know that a stock is going to increase a 100x, sure. Although we’ll talk about why that’s also risky in a different way too. But your gains are tax-free. That is true.
But your losses can’t be used to offset taxable capital gains elsewhere. Now, we know from past episodes that there’s a lot of skewness in stock returns. You’re much more likely to lose than to win the lottery. The other big downside of speculating within your TFSA is that you can also lose your TFSA room if you lose on a speculative bet. So if your investment goes to zero, if you put $6,500, if you max out your TFSA of 2023 and use that to buy a speculative stock, and it goes to zero, which happens. All of that room, your money’s gone, but all of that room is gone. You can never contribute that $6,500 to the account again, because remember, you get room back when you make a withdrawal. But if your investment goes to zero, you’ve got no more money to invest in the account, and you’ve got nothing to withdraw, the room is gone.
Now, this isn’t a fairy tale. It happens in real life. There was a Reddit post from someone recently, within the last couple of months that they lost – I think they had their TFSA maxed out or close to it, and they were investing in a stock that wasn’t even a crazy penny stock or anything like that. It was nothing too wild, speculative though. They had their money in that stock in their TFSA, and it went to zero, it delisted. They lost all of their money, and they lost all of their TFSA room. This is a real thing that happens.
[0:20:38] MS: Yes, that’s brutal. I mean, I’ve seen stories on Facebook too, not quite to that extreme, but there’s a lot of regret there. I’m filming this episode from the confessional booth of The Loonie Doctor Cave. I’ll make a two confessions and tell you that early on in my investing life, before I really understood about how markets work, and speculative investing, TFSAs had just come out, and I thought, “Okay, well, this is a small little account, it’s tax-free. I can use this to do some of my trading type of investing.” I was working with an advisor at the time, who would give me investment ideas and analyst reports. They were very much a stock-picking type of advisor. I thought that I was being smart, and I had some inside edge using an advisor, and I’d get these analyst reports.
So I used some of my money in my TFSA to do that, because I figured, well, I can buy, I can sell things without triggering any capital gains taxes. Because I think I’m going to do fantastic, this will all be tax-free growth money. But I figured out fortunately fairly quickly, actually, that’s probably not the likely outcome, and with a small amount of money that I was using. But I lost some of my TFSA room by doing that. My TFSA would be slightly bigger right now if I hadn’t done that. But it would be much bigger in the future just to do all that compounding, because if you have those losses in your TFSA, well those – when they compound over decades, it become a huge amount of tax-free money that you could have had.
I would say, it’s not a great place to learn those hard lessons about stock picking and market timing. If you have to learn them beyond just hearing the stories of others and hopefully learning from us.
[0:22:07] BF: Yes, I’m really glad you mentioned that. It’s always good for people to hear stories like that, because it’s a testament of the fact that personal finance is not easy. You’re the Loonie Doctor, but you had to gain that skill. It’s not an innate knowledge base that people just have.
[0:22:20] MS: No. That’s part of why I’m doing this, because I’d rather people not learn that lesson the hard way.
[0:22:26] BF: Now, okay. So, I mentioned that, even if you are wildly successful with your trades, there’s another risk there. CRA may deem you to be carrying on a business in your TFSA if you’re doing a lot of trading, and in that case, they can tax, or they will tax all of the gains in the TFSA as taxable business income. Now, the CRA looks at criteria including the frequency of transactions, the period of ownership of the securities, the taxpayer’s knowledge of the securities markets, and whether the taxpayer advertised that they are willing to purchase securities and making the determination of whether they’re carrying on a business or not. This is something that has been tested in tax court, it’s not just a fairy tale, again. so that’s a real risk.
[0:23:02] MS: I think the message there really is, if you lose as expected with speculative investing, then you lose, and you don’t get the capital loss that you can use to offset other gains and you permanently lose that tax shelter future growth, which down the road can be exponential. If you do get lucky, and you win, well, you may still lose to CRA instead. So not a great idea. That said, growing a large TFSA slowly over time with more reliable returns, has some pretty major perks later on in life.
With these withdrawals, when they do come out are not taxable income. So, you could use your TFSA in retirement to help you with some of your tax planning. So, let’s say you want to make a big splurge, and you need a bunch of money to pay for that, well, you can access this money without bumping yourself up a bunch of tax brackets. If you’re at a stage, a position where you’re collecting old age security, that gets clawed back if you have big income bumps potentially. So, this would be another way of accessing that money without getting OAS claw backs.
Let’s say you’re in a position where you never actually have to use it for any of those splurges, you have so much money in your other accounts that you’re using. Well, if you die, then your TFSA becomes a tax-free inheritance as well. So, it’s one of those ways that you can use that as a big account later in life, but you have to have grown it over a long period of time to get there.
Now, that brings you to another important point about TFSAs and death. If you die before your spouse, that TFSA can actually be added to their TFSA tax-free, just keep it into an even larger tax-sheltered space. So, this is another reason why you want to make sure that all the TFSAs in your household are being used to their full potential. Now, to do that, it is vital to name them as what sometimes called the successor holder, which you would do usually when you’re opening the account or whatever brokerage you’re using. But if you didn’t do that for whatever reason, make sure that you do it. You want them to be the successor holder, and that’s a different terminology and a different designation than a regular beneficiary or your estate. This allows them to actually get the full tax-free space. Even though your TFSA is controlled with after-tax money, it can be very, very useful to high-income earners.
[0:25:09] BF: Definitely, it’s a super powerful account. That successor holder point is super important. because if a spouse is named as a beneficiary, they get the asset, but not the account room. Whereas the successor holder gets the asset in the TFSA wrapper. They get to keep your TFSA bag, which is very valuable bag.
[0:25:26] MS: That’s awesome.
[0:25:27] BF: Yeah, it is. But it’s a little nuance that people don’t know. You see the formula, it says beneficiary or successor holder. How would most people know the difference?
[0:25:37] MS: They’d listen to our podcast.
[0:25:39] BF: Yes, that’s right. That’s exactly it. Okay. Before we leave TFSAs, I do want to touch on one other nuance of investment taxation. This is, again, something that we’ll elaborate on much more in our next episode, but interest Canadian dividends, and realized capital gains, and foreign dividends are all tax-free in the TFSA. So you don’t pay any Canadian income tax on those types of income inside of a Tax-Free Savings Account. Whereas in a taxable account, you would owe income tax. Now, foreign dividends, again, not taxable in the TFSA. But when a foreign company pays a dividend to a Canadian investor, there is a withholding tax often charged by the country where that stock or fund is held.
So if a foreign stock pays a dividend foreign to you, so we’re in Canada, if a company different country pays you a dividend, they often have to withhold tax on that dividend. Because the dividend is being paid to a foreign account holder. In a taxable account, you can typically recoup that foreign withholding tax, but not in the TFSA. Because the TFSA has no tax anyway. In the taxable account, you get a tax credit, but because the TFSA, there’s no taxation, there is no tax credit. So we call this unrecoverable foreign withholding tax cost. And then that can happen when you hold foreign securities in your TFSA account.
Now, really importantly, this should not be a deterrent to using the TFSA. I’ll give a quick example. If we take a 2% US source dividend, there’s a 15% foreign floating tax rate. So there’s 0.3% withholding tax cost in the TFSA. If you receive a US dividend, there’s about 0.30% cost. Now, that is way less tax drag than the Canadian income tax on that dividend if you had earned it in a taxable account, even at the lowest tax bracket. So yes, there’s a withholding tax costs for holding foreign securities in a TFSA and in an RRSP. But we’ll get to some more details on that later. But it’s still probably much better than holding it in a taxable account. I give an example where it’s about 0.3% foreign floating tax cost. There are cases where that foreign withholding tax costs can get closer to 0.6%. Now, that happens when you own a Canadian-listed ETF that holds a US-listed ETF, that holds international stocks.
[0:27:53] MS: Wrappers within wrappers.
[0:27:56] BF: Exactly. So the result there comes from the fact that there are two layers of unrecoverable tax. One when the foreign non-US company pays a dividend to a US ETF and another one when the US ETF pays a dividend to the Canadian ETF that you own in your account. Now that is being aware of when you’re choosing funds, because there are funds now for, I think the major asset classes in Canada now. Because the iShares emerging markets fund has moved to direct holding, so there are funds that you can access in Canada that hold all securities directly, or at least are moving in that direction. So that’s definitely something that’s worth considering when you’re choosing which funds to buy.
It’s also important to remember that foreign withholding tax is only on part of the return. So the 2% dividend example, if that stock rose 6% in price, all of that appreciation is still tax-free in the TFSA. I have seen people ask, “Should I own my foreign stocks in a taxable account to avoid those scary-sounding foreign withholding tax costs?” Usually, the answer is no. Even after withholding tax, the TFSA should be more tax efficient than a taxable account, including for foreign stocks.
[0:28:58] MS: I’m missing out on Canadian tax is better than just paying a little bit of foreign tax.
[0:29:03] BF: For sure, yes.
[0:29:05] MS: Okay. Well, I think that brings us through all the TFSA. So we’re going to move on now to the Registered Retirement Savings Plan, or RRSP. We’ll talk about both regular RRSPs and spousal RRSPs. Now, these accounts have been around for a long time since 1957. So most people have heard of them. As the name suggests, these were designed to save for retirement. That also explains the main attributes that they’ve got. However, they can also be used for some other purposes as well. So over time, that’s evolved. But again, retirement’s the main thing.
In contrast to the TFSA, the RRSP is what we would call a pre-tax account. What that means is that pre-tax dollars go into the account, and then you’re going to owe taxes in the future at some point when you take that money out. That’s done by giving you a refund on your taxes now and they’re going to pay the taxes later on a withdrawal. The contribution room of an RRSP is tied to your income. So it’s like how a pension would be and there is an interaction between your RRSP room and any pension that you might have, because that’s how this has been meant to function.
What basically happens, you get 18% of the previous year’s earned income, and that includes your usual T4 income, plus, it also includes net rental income, and spousal support payments, so those can add into the income off which that 18% is calculated. That goes up to a maximum each year, which rises a little bit each year tag to inflation. The max contribution room for 2023 would be $30,780. That corresponds to having $171,000 of earned income. There is a cap that’s put on there, but it’s at a pretty high income level.
It’s important to note that interest and dividends do not generate RRSP room. This is something that’s important, especially for corporation owners who may be deciding how to pay themselves. Giving dividends does not do that. It has to be salary type of income, or spousal support payments, or net rental income. There’s a few other less common types of income, but that’s the main ones we’d have to worry about.
The other thing to know about contribution room is that, if you don’t use that room in a given year, then it’s not lost, it actually does carry forward and you can use it again in a future year. So, you can contribute in a given year [or in a future year instead].
But, you can also delay the deduction against that income until a future year as well. This is important because this confuses people.
The RRSP contribution room and the deduction limit are actually different numbers. So let’s say, you earn $100,000 of income, that’s going to give you $18,000 of new RRSP room for the following year. Let’s say, you contribute $18,000 to your RRSP, but you don’t deduct that contribution against your income taxes that year. Well, you now have $0 of RRSP room because you’ve used that $18,000. But because you didn’t deduct it against your income, that’s carried forward, and you still have $18,000 of deduction available that you can put against your income in a future year.
That deduction carrying forward is really important, because it can be one of these ways that you can plan to take advantage of one of the RRSP’s main tax characteristics. The tax deferral to the future is hopefully going to be at a lower tax rate. When you contribute to an RRSP, the dollar is deductible, dollar for dollar against your personal taxable income. So that’s 100% tax deferral on the amount that you contribute it.
Now that can mean more after-tax money down the road in the future. If you take that money out at a lower tax rate, and then you pay lower taxes in the future. I’ll just give another example. Let’s say, I contribute $100, and I’m in the 54% tax bracket now, and I deducted against that 54% tax bracket now. And then I take it out later on in retirement while I’m in the 30% tax bracket. Well, then I’ve avoided losing 24% of my money to tax because I’ve shifted down. Deferred it to a future tax bracket that’s lower.
That’s a big gain even if I didn’t even invest the RRSP money, just the tax shifting to the future and in a lower bracket is a big gain on its own. Most Canadians will have a lower tax bracket in retirement, than in their big earning and consumption years. That’s why the RRSP works well for that purpose.
[0:33:10] BF: Yes, that benefit is huge, and it can’t be understated when it works out. But it can also be a bit of a double-edged sword that’s worth mentioning. So if you use the RRSP deduction in a low-income year, and then have a high tax rate in the future, it could actually make you worse off. Now, worse off is relative, and in our case conference, we’ll get into an example there to talk about some of the numbers.
But basically, if the alternative is a TFSA, the margin for higher future tax rate is relatively low. Whereas, if you’re comparing the RRSP to a taxable account, you have a lot of room where your future tax rate could be quite a bit higher than your current tax rate, and the RRSP still makes you better off than a taxable account. Anyway, we’ll come back to that later.
Now, the RRSP’s got another big advantage in addition to the income tax deferral. Mark, you mentioned that having a lower future tax rate, that’s beneficial even if you don’t invest. But the cool thing is, that investments inside of the RRSP, they actually grow tax-free, just like a TFSA.
So that is what gives you a lot of room for error with the RRSP, even if you do end up at a high tax rate in the future if the alternative is investing in a taxable account. We’ll talk with these numbers more in the case, but I think it’s about a 13%. This is rough numbers just based on a simple model to illustrate the point.
But when I’ve looked at this, it’s about a 13% jump in tax rates between current tax rates and future tax rates for the RRSP to make you worse off than investing in a taxable account. But that does also make it really important to weigh the trade-offs between the RRSP and the TFSA. Because in that case, both allow tax-free growth, but the RRSP’s main advantage over the TFSA, is that income tax deferral to the future.
It’s a common rule of thumb to say the tax deferral is good, and it usually is. Usually might not be the right word. Usually, for high-income people, it is. Usually for low-income people, it can actually be worse. I’ll talk more about that in a second.
But even for higher-income people, or high-income trajectory people, this can be particularly relevant if you’re growing your wealth and income over your lifespan. Tax deferral can end up being neutral, beneficial, or harmful, depending on the difference between your current and future tax rate. Now, the important part, and the part that makes this tricky, and a bit of a risk, it’s an unknown.
The difference between your current future tax rate depends both on your current and future level of taxable income. That’s the thing where it’s like, okay. If you’ve got a low income now and expect to have a higher income later, so that’s one consideration. But it also depends, and this is where it gets tricky, on current and future tax rates at that level of income.
We know as of 2023, you know roughly what your taxable income is going to be, and you know what the tax rate is on that income. But in 2060, or whatever, you don’t know what your income is going to be. But even if you did, you don’t know what tax rates are going to be at that level of income. So that’s where it gets a little bit tricky. If current and future tax rates are the same, then tax deferral is neutral, and you gain from tax-free growth inside the account, so that’s good. If you pay the same tax rate to access the money later, you just get the tax-free growth. But if you end up paying at a higher tax rate in the future, that’s where it can be a little bit dicey. And if you end up paying a lower tax rate in the future, that’s where you’re getting effectively a bonus.
[0:36:07] MS: Yes. I mean, this is an actual risk. I mean, we’ve already seen. I remember when I first started practice, the highest tax rate in Ontario is around 48% or something, and now it’s pretty much 54%. That all juiced up over the course of a few years. So I mean, that’s not impossible that it could go up more in the future, we don’t really know that. But this whole concept is hard for people to believe, and we do have fortunately some of that wiggle room that you mentioned. So people will have a hard time accounting for the fact that there’s taxes owing on it when they do look at their RRSP. Because what they see is they see the number that’s in the investment statement, and they don’t automatically calculate the fact that there’s a tax liability that’s baked in there.
I’m just going to give some of these examples contrasting the RRSP versus a TFSA, because it’s the simplest example I can use. It’s 100% tax deferral in the RRSP, whereas TFSA is after tax, and they’re both tax sheltered. That growth in between should be pretty close to each other. We will ignore some small differences in foreign withholding taxes. But let’s say that you have a 50% marginal tax rate now, and that you will have that in the future too, although, we don’t really know that, but let’s assume that just to make the math easy.
Let’s say you have $100 of income. So if you take that $100, and you put it into an RRSP, and you take the deduction, then you have the full $100 to start. That’s pre-tax. If you take the money that you’ve earned $100, and you want to put it in a TFSA, well, you have to pay tax on that first, so you pay 50% tax. That leaves you $50 to invest. So the RRSP is going to have more money to start out with. Now, you take those accounts, you let them compound grow at 8% a year annually, do that for 30 years. The RRSP would have about $1,000 in it. The TFSA, because you started with that smaller amount of money would only have about $500 in it. So the RRSP looks like it’s much larger than that TFSA. However, that $1,000 in the RRSP is what we call pre-tax dollars. It still has that 50% tax liability baked into it to get the money out, because we’re assuming that’s the future tax rate is.
So if you take that out in the future, pay 50% tax on that $1,000. Well now, you have $500 left, and that tax-free money in the TFSA comes out tax-free. So it’s exactly the same, both would have $500 after tax. It’s just about where the tax is charged at the beginning or the end. Now, where an RRSP could result in tax savings, of course, in addition to the deferrals if that future tax rate is less than the current tax rate that you’re avoiding. So in our example, if your future tax rate was only 30% instead of 50%, well, then you’d have $700 after tax using the RRSP, which is $200 more than the TFSA. So that assumption that people are going to have a lower income during retirement is why that idea of tax deferral is always good is a rule of thumb that’s thrown out there. But as we’ve discussed, that’s not actually a rule of thumb that necessarily always applies. I mean, we don’t really know that, particularly for growing our wealth and income over our lifespans. And we don’t know what tax rates in the future are going to do, particularly at the higher levels of income. I think those are the most vulnerable areas.
[0:39:09] BF: Oh, yes. I’ve got a chart somewhere, I should have pulled that out for this episode. But I’ve got a chart showing the highest marginal tax rate in Ontario going back to 1920. It’s wild at the highest rate, and nuance though. So I don’t remember when. At some point, the highest tax rate converged, but for a long period of time, the 99.99 percentile tax rate was quite a bit higher than the 99-percentile tax rate anyway. But the actual highest tax rate was very few people actually paid, but the highest tax rate was in the mid-70 %.
[0:39:40] MS: Yes.
[0:39:40] BF: Rate for a while.
[0:39:41] MS: Yes, there’s room to go up in precedent.
[0:39:43] BF: Yes, it wouldn’t be unprecedented at all.
You mentioned a small detail about foreign withholding tax. Since we’ve got the push-entero-scope out today, I think we’re going to be looking at the small details here. So the RRSP can have a slight advantage on foreign withholding tax compared to a TFSA. Because dividends from US-domiciled stocks and ETFs are exempt from US foreign withholding tax when they’re held in the RRSP account. The TFSA was too late to the game to be covered by this tax treaty. The Canada-US tax treaty, the RRSP was covered. and so we’ve got this special treatment for US assets held in RRSP accounts.
Now, this is good news, because the US market is huge. It makes up a large portion of most equity portfolio just based on its size. So if we take the RRSP and the TFSA, as the two alternatives, like in your example, just now, an RRSP holding us listed US stocks, or a US-listed ETF of US stocks. It’s got a little bit of built-in buffer over the TFSA, even if future tax rates are a little bit higher, just due to the difference in foreign withholding tax costs. So I ran some simple numbers with this, and I found that over – I think I looked at their 30-year period. The foreign withholding tax cost advantage buys you about a 3% to 5% increase in future tax rates, relative to current tax rates for the RRSP to still beat the TFSA if it’s holding US stocks. Assuming that we’re holding a US-listed ETF in the RRSP and not in the TFSA, but otherwise, they’re earning the same return.
Now, that point only matters for a US equity held in RRSP account. My quick numbers don’t take into account the costs of currency conversion, or the implicit cost of added complexity for slicing and dicing your portfolio to include US-listed of ETFs as opposed to just holding a single Canadian-listed asset allocation ETF, which as we’ve talked about in past episodes can really help to improve behavior. But it is a detail we’re thinking about, again, because we’ve got the push-entero-scope out here.
If the alternative to an RRSP is instead of taxable account, that’s where it takes that big roughly, say it’s a 13% jump between the current and future tax rates for the RRSP to actually make you worse off than a taxable account. Again, we will cover that in one of our cases. But I think a main takeaway from this segment is that the long distant future is unpredictable. We can’t know our future taxable income or the tax rate on that future income, even if we could predict the future income. But even so, it’s probably not a good idea to avoid using the RRSP, or its tax deduction, because you’re afraid of having a high income in retirement.
In the short term, if you have a likely big income bump in the near future, it may be worth focusing on your TFSA first, or keeping some of the RRSP deduction available. Although, that’s a bit of a minefield too. If you carry your deduction forward too far, there’s an opportunity cost and it can actually make you worse off. Anyway, TFSA first. We have a case where we’ll dive into thinking about that. Now, there are some cases, and I briefly touched on this earlier, but there are some cases like when your current income is low, or your marginal tax rate is low now, and you do not expect to have much income or taxable assets in the future. In that case, the RRSP can actually be quite detrimental. Low-income Canadians can qualify for the GIS, the Guaranteed Income Supplement, which is clawed back very quickly with taxable income like that from an RRSP withdrawal.
So if you’re making RRSP contributions now that results in minimal tax deferral, because you’re already paying little to no tax on your low income. And those contributions when they’re withdrawn in the future result in GIS being clawed back, that ends up being a really bad and avoidable outcome. For low-income planning, the RRSP will tend to be less suitable.
[0:43:10] MS: Yes. I think when you’re talking to people in low-income brackets, what’s lost in some of the politics is that TFSA is really, it’s a gift to the lower-income folks, because it’s flexible, it’s after-tax money, it doesn’t result in clawbacks. The RRSP is a gift to higher-income folks, because it’s deductible against those high-tax brackets.
There are some situations that we can take this obvious jump in income that’s coming up, and it does actually apply to us. There are some common examples. One would be the jump from resident to attending physician, that can be pretty predictable. It’s going to be a big jump in income.
Now, a lot of people don’t have much money to invest at that point. But if they did, and they put money in their RRSP, that would be a case for delaying using the deduction for a year, maybe two might be worthwhile if you’d know that’s coming. The same thing can happen even when you start your practice. It can take a while to actually build up your income over the first few years. There’s other situations where it could happen to you.
So another entrepreneur may face their first big vesting cliff for stock options or restricted stock units from an employer, and they’re going to have this predictable, large bumping their income that they can plan for. Another common thing would be a big capital gain from the sale of some secondary personal real estate, or a business that you know is going to happen in the near future. So using that kind of deduction to offset a one-off big income year could be worth delaying a few years.
As you mentioned, it’s not something you would want to delay for someone selling the family cottage 20 years from now, maybe. You’d have so much opportunity costs and uncertainty there, that it’s not worth it. But if it’s going to be in the next one or two years, there’s some tax planning opportunity that’s there for you.
The other way that we can use RRSPs for tax planning is to use a spousal RRSP. What a spousal RRSP is, it’s a special type of RRSP that can be used not only to defer tax like an RRSP does, but also to shift that income over to a lower-income spouse. So that when it comes out in the future, it would come out taxed in the hands of that lower-income spouse.
Now, the spousal RRSP, the way that it works is owned by that lower-income spouse. The higher-income spouse would earn contribution room for their RRSP based on their income, and they could use that contribution room, instead of contributing to their own personal RRSP contribute to their [spouse’s] spousal RRSP, instead. This is something that’s different from any RRSP room that the spouse themselves would be having. This is based off of the high-income spouse’s income. And of course, you can then deduct that against your high income at the higher tax rates as well.
Now, where it gets kind of neat is that after two full calendar years of no contributions, when that money comes out of the spousal RRSP, it gets distributed to the lower-income spouse to be taxed at their low tax rate. In addition to that, because this is separate from their own RRSPs, they could actually be contributing to their own RRSP, or their work pension, or whatever they’ve got in addition to that. So this is a way of shifting taxable income from the high-income spouse (say you’re at a 54% tax rate), shifting it to a lower-income spouse, who you think is going to have a low income during the time when you draw it. Well, you’ve not only deferred tax, you’ve more reliably shifted it down to a lower rate.
After the age of 65, this doesn’t make as much of a difference because you’re able to pension split once you’ve turned your RRSP into an RRIF, which is the switch that you make when you’re going to start taking money out of it. So you can start to income split at that point. But if you want to income split at a lower age than that, then having your spouse with a larger spousal RRSP, if they’re at a lower income could give you some more options.
The other little nuance in there is that, even when you can pension split, you can’t pension split an RRIF by more than 50:50. If they’re given extreme case, where there’s extreme difference between the size of the RRSP is actually having a spousal RRSP might give you some more opportunities to do some better even pension splitting.
Now, just to clarify, because I’ve mentioned it a couple times there. What RRIF is, is a Registered Retirement Income Fund. You can convert your RRSP to RRIF at any age. But once you do that, then you have to start taking the minimum withdrawals each year moving forward. The amount you have to take out is based on your age. It’s pretty small when you’re younger, but then it gets larger towards the end of your life. Even if you do make that change from an RRSP to an RRIF, it is possible to transfer money back from an RRIF back to an RRSP. That is possible to do that. However, you’d have to convert all your RRSPs to RRIFs by the end of your 71st year. It’s not like you can defer taxes forever. But in the meantime, the RRIF has the same tax sheltering advantages that an RRSP does.
One question that often comes up when I discussed the whole idea of using spousal RRSPs for income splitting is, “What happens if we split up? What happens if we get divorced?” The answer to that is actually, all RRSPs, and all of your invested assets that have accrued during the time of your relationship are all going to go into that big pot that gets divided up by whatever the divorce settlement is. So you don’t just lose it, it doesn’t matter whose name your RRSPs are in, that all gets put into the same pot.
[0:48:12] BF: Definitely worth mentioning that. To close out this section on retirement-related registered accounts. Another account to be aware of are LIRAs, Locked-in Retirement Accounts, and LIFs, Life Income Funds. LIFs come from LIRAs. Talk more about that though. If you’ve got a pension through an employer, and you commute that pension, you take the cash value of the pension, typically what will happen is, there’s going to be what’s called an in-amount and an out-amount. The in-amount of goes into a LIRA. That’s the amount that remains tax deferred. The out-amount comes out to you as taxable income in that year when you take the commuted value. But in a lot of cases, if someone’s been in a pension for a long time, they can end up with a very large LIRA, a very large Locked-in Retirement Account.
It’s very RRSP-like, except that you can take money out of it before age 55. If you have the LIRA past age 55, then you can convert it to a LIF when you want to start drawing income from it. The main difference between a LIF and a RRIF, is that a LIF has both a minimum annual withdrawal, and also a maximum annual withdrawal based on your age. Whereas with a RRIF, you can take out however much you want, but you have to take out a minimum. With the LIF, you have both a minimum and a maximum. You can convert some or all of your Lira to an RRSP, which is beneficial to the RRSP being less restrictive. You may be able to. Now, you can.
It’s lots of different funny little rules about when you can do it. One that we often see in practice is a small balance. If you have a small balance in your LIRA, you can do a small balance on locking, where you can take the LIRA asset and put it into an RRSP. In some provinces including Ontario, you can also unlock 50% of an Ontario LIRA at the time that you convert it to a LIF. When you convert your LIRA to a LIF at that time, you can unlock 50% of the amount that was in the LIRA and put it into an RRSP account. There are a couple of other funny little ways that you can unlock parts of a LIRA, but we’ll leave it there for now.
All right. Now, we’re going to move on to the new kid on the block, the FHSA, the First Home Savings Account. This one was just legislated into existence this past year. It has started being offered by some financial institutions as an account option. Some have been slower to roll them out. It can be opened at quite a few places now, though. And where you open it, again, as we mentioned earlier, is going to dictate what you can invest in just like the other accounts. Some of the nuances of this account, and how it works, and what its implications are still being fleshed out. But it is pretty clearly a very powerful tax shelter. Whether or not it’s good housing policy is a different discussion, and we won’t go there.
It’s got a 100% tax deduction on contributions like an RRSP does, but it may actually result in tax elimination, as opposed to deferral. Because if the money is withdrawn to buy a first home, then it actually comes out tax-free. So you’re getting a deduction going in. And if you’re using it to buy a first home, you’re getting to take the money out tax-free, as if it were a TFSA. Except that you got the deduction on the contribution. It’s also got the same tax-free growth characteristics of the RRSP and the TFSA.
It’s effectively a government-subsidized downpayment savings vehicle. Even if you don’t use the money to buy a house, it can eventually be transferred into an RRSP. That’s on top of your usual RRSP room. That’s pretty crazy. This came out after I bought my house and I’m pretty annoyed. It’s powerful. There are some details to be aware of, though if you’re going to open one.
The first is how contributions work. You get $8,000 per year starting when you open the account up to a maximum lifetime contribution limit of $40,000. Now, the pitfall here is that you can lose unused room. So you don’t want to open the account until you’re going to contribute to it regularly. You can make up for one missed year by contributing up to $16,000 in the following year, but unused room beyond $8,000 of carryover is lost, which that could be unnecessarily painful.
The contributions as I mentioned earlier are deductible against your income like an RRSP. You can deduct in the current tax year, but you can’t take a contribution in the first 60 days of a calendar year and apply it backwards to the previous year, which is something that you can do with your RRSP. Like an RRSP, you don’t need to make the deduction to your income right away, you could carry it forward to use in a future higher income year, even after the account is closed.
[0:52:24] MS: Yes, it’s a very, very powerful account. I think the biggest restriction for this account is being eligible to actually use it. So to open a TFSA, you have to be between the ages of 18 and 71 years of age, you have to be a tax resident of Canada, and you have to have not lived in a home owned by either you or your partner in the current calendar year or the preceding four calendar year. So basically, up to five years.
To take that money out tax-free, on the other end, it also must be to buy a qualifying home in Canada. So you can’t go use it to buy some foreign property.
Now, there is a fair bit of flexibility, but what you can use to buy, it could be a house, it could be a condo, it could even be a coop as long as you have equity participation in the coop and not just tenancy rights. So there are some pretty broad range of usage for it. One of the things that people do need to be aware of is that there is also a time window for the withdrawal. So it cannot be more than 30 days after you acquired the home, and you must also close before October 1st of the following year. That can be important if you’re doing a new build, for example. Because if there’s delays in construction, and you’re not planning this properly, that could be a bit sticky for you.
Now, you also have to be intent to occupy that home. So you have to intent on occupying it as your first principal residence within one year of acquiring it. So you can’t buy it and let it sit empty. You have to make it your principal residence. When you go to make this withdrawal, there is a government form that you’d have to fill out to do that. So it actually goes through all of these criteria there as well. But it’s better to be aware of that in advance than be planning and executing your real estate purchase without falling within that time window and finding out after the fact.
[0:54:01] BF: Yes, you would hope that a mortgage broker would talk you through that too. I know when we got our house, our mortgage broker, they knew at the time the homebuyer’s plan rules because we weren’t using the FHSA. But they knew all that and made sure it was all going to work out. But yes, one of the many other areas that mistakes can happen.
Another spot on this that people can get hung up is in how funds move between an FHSA and an RRSP. You can move money from an RRSP to an FHSA without triggering a tax event as long as you don’t exceed your FHSA contribution room. But the downside of doing that is that, if you then spend it on a house, you never get that tax-sheltered room back again. So you’re giving up your RRSP room to take it out in a tax-favorable way. But you’re also giving up that RRSP room. If you have enough money, funding the FHSA directly probably makes more sense, because then, you’re getting the FHSA room, and you’re maintaining your existing RRSP room.
Now, that’s in contrast to the first-time homebuyer’s plan. That’s where you can take money up to $35,000 out of an RRSP tax-free, or borrow it tax-free. You don’t have to repay it back into the RRSP over 15 years. So those are two different ways to fund the home purchase using the tax-deferred vehicles. Now, the good news with the homebuyer’s plan and the FHSAs, that if you have enough money, you could do both. You could use, fund an FHSA, and you could also use your first-time homebuyer’s plan from the RRSP.
[0:55:22] MS: So basically, the FHSA is like the newborn housing-obsessed love child of a TFSA, and an RRSP. It combines features of both those accounts together into this basically tax elimination type of account. There’s 100% tax deferral like an RRSP up front, there’s tax-free growth along the way, and then it comes out tax-free on the other end, but only for buying a first home. Now, whether that’s going to help us with our housing costs, I’m not sure as you mentioned.
But I think this is an opportunity for those of us with adult kids. If we have extra money, it’s a way of gain passing money on in a tax-sheltered way not to us, because we’d have to give that money to them. It would be deductible against their income. But it is a way that they could have a tax deduction, tax-free growth, and then tax-free money to purchase a house with if there is extra finances within the household available. That leads us towards our next account types, which are other ways that we can help our offspring, and those would be the RESPs and the RDSPs. We’ll tackle the RESP first.
[0:56:25] BF: The RESP is another one of the common account types. This is another one of the ones that people have probably heard about, especially if they have kids. It’s been around since 1974, and it’s intended to help with funding post-secondary education costs. Like the TFSA, and that the contributions to the RESP are made with after-tax dollars. But the difference between the RESP and the TFSA – well, there are bunch of differences. But another one of them is that there are matching grants paid into the RESP account when contributions are made. We’ll detail those grants more in a minute.
Investments can be held inside of an RESP just like the other types of accounts that we’ve mentioned. Other than the grants, a big benefit of the RESP is that all growth in the account is tax-deferred. And then as long as the beneficiary of the account enrolls in post-secondary education, that growth can be withdrawn taxable to the beneficiaries, taxable to the child, who presumably has a low income while they’re a student. So it’s not tax-free like the TFSA, but it shifts the tax liability from the parent or whoever opens the account to the beneficiary.
One of the common misconceptions with the RESP is that you buy an RESP from the many sales organizations that chase you down in the hospital right after you’ve given birth. I don’t think that they’re doing that anymore, because I think that there was a big lawsuit.
[0:57:38] MS: Yes, I think they got kicked out from that.
[0:57:40] BF: Yes, but I know one. We had our kids, I don’t know if the most recent child if we had this experience. But for sure, for my firstborn, which is eight years ago now. We had promotional materials from a group RESP providers in our paperwork package from the hospital. But the crazy thing is, all these government forms and whatever, and then you’ve got this thing, and so it feels official. The language on these products also is designed to be or I would assume it’s designed to be, but it certainly appears to be a very official. It’s got all kinds of names that make it sound like it’s some sort of scholarship, or philanthropic, or I don’t know, just a very prominent sounding organization. But I mean, we’ll talk more about why they’re not in a minute.
[0:58:22] MS: They may not be allowed to do some of the stuff they did before. But these are ubiquitous all over the place. I remember actually sitting at our kitchen table, and my parents signed up to one of these when I was younger, and I felt like I was so smart, because I’d won a scholarship. But really, it was just buying into a group RESP plan. I know a lot of friends and family who have bought into these plans. My wife and I were just talking about that last night, and they don’t realize what they’ve gotten into until later on. Then they often have some buyer’s remorse.
So we’re going to actually talk about that in our case conference at the end of this. Because at early parenthood, that is a very vulnerable time, and people often go down the wrong route, not understanding what they’re doing. So I do feel like we’re using the money scope in this section to snare remove these precancerous polyps. So we’re going to talk a bit more about RESPs. But really, one of the biggest things to understand is the difference between a group RESP and an individual or family RESP. That’s one of the biggest things to understand before you get too far into it.
[0:59:24] BF: Super important. I was talking to a friend about this yesterday, and he mentioned that he figured these things probably put less affluent people in a worse situation because more affluent people are maybe more likely to work with a financial advisor, so they call. When our clients have kids, they call us and say, “What do I do?” And we open an RESP for them that they can then hold low-cost index funds in. Whereas, someone who doesn’t have that type of relationship or maybe isn’t following a blog like yours, Mark, they just assume that this is what you do. But I agree it’s an important opportunity to remove these polyps.
[0:59:56] MS: And you feel so responsible while you’re doing it too.
[0:59:59] BF: Totally. So what these group RESPs do is they bundle the account, the RESP account with products and management of investments through this complex contract. So the way that they tend to work is that you buy units in their plan. It’s a contract that you’re entering into, to buy these units. And there’s a whole bunch of covenants and restrictions on how it all works. The promoter company is going to manage the investments. When you go to access the money in the future, the promoter also has control over the distributions. Now, these plans have large sales charges, and this is one of the big issues. Not the only one, but one of them.
They’ve got big sales charges and fees that are not always easy to see or to understand, and the literature for these things describes access to the incentives and the grants, but those are table stakes. Any RESP gets access to the grants. The group RESPs don’t give you anything special in that respect. As you mentioned, I mean, we refer to them as cancer. So generally, they should be avoided if that wasn’t clear. You can open an individual RESP, and invest yourself, or through a financial advisor. That’s going to be much more flexible and typically lower cost. If we want to get into details, it’s probably going to have a higher expected return, depending on what you invest in, I guess. If you’ve already signed up for a group plan, and you’re worried that you’re hemorrhaging money, don’t worry too much, we’re going to fire up the money scope, cautery probe in the supplemental case conference episode to talk about some of the things that you can do there.
[1:01:21] MS: All right. So an RESP can be opened anytime after the birth of the beneficiary. So the person opening the account is called the sponsor, and they actually legally own the accounts. So it’s not owned by the kids, it’s owned by the sponsor. That would usually be a parent or guardian, it could also be a spouse. So that’s the sponsor of the RESP. Now, the contributions, they can be made by anyone, so it’s commonly relatives, or close family friends.
The thing to be aware of, though, is there is also this lifetime contribution limit, which is $50,000 per beneficiary. So you have to make sure that all contributions don’t add up to exceed that. Those contributions can be made at any time. Most people do it regularly. but it can be done any time. The other thing to be aware of with that is there’s also grants that go with the contributions, and there is a rate-limiting rate at which those grants get doled out.
So you can have a maximum amount of grant in a given year, and if you put more money in beyond that, you don’t get extra grant. So the main grant to be aware of is the Canadian Education Savings Grant or CESG. The way that works is it’s 20% of the contribution up to a maximum of $500 per year. So if you put in a $2,500 contribution, then you should get the max grant that goes with that. Now, that’s $500 per year, but you can also make up for missed years as well. You can do that at a rate of – on top of that, an extra $500 of grant per year, so $1,000. Now, the maximum for that over the lifetime of the beneficiary is $7,200.
The other thing I think I should mention about CESG is there is an age limit on that too, when they’re younger. So once they get past the age of 18, then they don’t get that grant anymore. So there is a bit of pressure to start putting the money in early, and to also dole it out over a period of time that you can try to take advantage of that grant.
[1:03:11] BF: Yes, definitely. Families with an income under $107,000, they can get the CESG grants a bit faster with an extra 10% to 20%, depending on how much lower their income is on the first $500 contributed each year. The lifetime maximum grant though is still the same, at $7,200. There’s also a Canada learning bond which applies to children in low-income households, and the bond is not contributory. You don’t have to make a contribution to get the grant. But it does require an RESP account to be opened. I think there’s actually even an additional $25 credit for opening the account to account for the cost of opening it. So if you have a low-income household and you open an RESP, you get the bond plus a $25 credit in the account.
Some provinces like BC and Quebec I think are actually the only ones now, they can also have additional grants that get paid in provincially. And you just got to make sure that you apply for those when you open the account if you’re in one of those provinces. Blood relatives or legally adopted relatives can share a family RESP. With a family RESP, and this is distinct from a group RESP that’s worth mentioning, because family RESPs can be quite good, while the group RESPs as we mentioned tend to be not so good. With a family RESP, you still get access to the same grants per child. While the use of the grants is limited per child, so each child can only withdraw up to a maximum of $7,200 in grants. Any excess earnings in the account, so that’s earnings on the contributions and earnings on the grants that can be used by any of the children.
So you could have a situation where there’s three kids or say, it’s two kids in a family RESP account. If one of them goes to post-secondary, qualifying post-secondary education, and the other one doesn’t. The child that doesn’t go to post-secondary, they do have to give their grants back to the government. But their earnings in the account which have accrued both on the contributions and on both kids’ grants can be withdrawn as a taxable payment by the child who does go to post-secondary education. So you got a little bit more flexibility there in terms of how the growth can be used. The brokerage that you’re using to open the account is going to be considered the promoter, and they’re going to be the one that applies for the grants on your behalf. So again, you want to make sure that the grants are being applied for in the first place. And then if you’re in BC or Quebec, that you’re also being applied for the provincial grants.
[1:05:22] MS: Yes. I think it’s important to be aware that some discount brokerages don’t actually administer the BC grants. So you have to make sure that whatever one you’re using actually does handle it, because I have heard of some that don’t.
[1:05:33] BF: Interesting.
[1:05:34] MS: Yes, people can get caught in that. The other thing I want to just mention without getting too deep into the weeds, because it always comes up is how you can optimize the contributions to your RESP. So it’s this balance between trying to maximize the amount of time that you have that tax-free growth, but also against putting the money in too quickly as a too large of a lump sum upfront, and then losing some of the grants because of that, because they’re only get given out at a certain rate per year. So there’s these trade-offs that could happen between that tax-sheltered growth, and then the grants that come with it.
So I’ve written a whole bunch of articles about this on my blog, over the years. But the one thing I would say before even mentioning, that all of these strategies are sensitive to a bunch of assumptions about investment returns, what the student’s tax rates going to be when they take the money out eventually, because it does actually get taxed, it’s not tax-free. But I think there’s different approaches you can use them. One would be to basically not lose out on any of the grant, but try to get as much money in as early as possible to take advantage of that tax-sheltered growth. One approach would be to take $16,500 at birth, or within the next year after birth, put that in there. Then $2,500 a year after that, until you’ve reached out to that $50,000. By doing that approach, you wouldn’t lose out on any of the grants, because you’d be spreading that out enough over time that you still get all that grant money. But it does give some extra tax-sheltered growth for that initial lump sum that you put in there.
Now, you could put a more aggressive front-loaded lump sum if you thought that the tax-sheltered growth was going to outpace any grant money that you lost to be more aggressive with it. And you know, that can work out mathematically if the returns are really high, the student income is really low, and the alternative to that money because you have to have the assumption that you’ve got that money sitting there to invest if the alternatives is putting it in your own taxable account, and investing it at a very high-tax rate. Well then, the RESP would have more of an advantage.
So if you look at extreme situations, it can work out. But what I would say having looked at it is that the differences between all the different variability of that is quite small, and it’s sensitive to all of those future events that you really don’t know how that’s going to unfold, where I would say that grant money is guaranteed.
[1:07:48] BF: I’ve run these models too, because it’s super fun to play with. But I found the same thing. It’s like, if you make optimistic assumptions about growth, you can end up at about the same place with fully front-loading it, versus doing – we call it super funding, dumping the $14,000 in plus the $2,500 in the first year, and then using all the grants after that. You end up at about the same place. But the grant option is much less sensitive to assumptions, because you’re getting the grants, like landed in the same place as you.
[1:08:14] MS: Yes. The only reason why I still have the articles up about that on my site, and I still talk about it like today is because people really want to do this, they want to optimize it. I think it’s important to know that it’s been looked at, and it probably doesn’t matter that much, and don’t delay. The biggest thing you could do is use your RESP early. And of course, avoid a high-fee plan, but use it early, and let time do the work for you. Don’t delay and lose time because you’re trying to nuance some small variable.
The other thing I would say is, I have looked at this for incorporated professionals too, because this becomes another layer of complexity there. Most incorporated professionals have all of their excess money invested in their corporation beyond their registered accounts. So, they don’t have a bunch of excess personal cash sitting there to invest. For them, front-loading in RESP by taking out more, and putting a big lump in would mean taking more money out of their corporation in a lump to do that.
There are ways that you can take money out of corporation very, very efficiently. If you’re in a position to do that, which we’ll talk about in future episodes, and sure, you could get that money out at a low cost. But usually, it means you’re going to lose corporate tax deferral, because you’re going to have to pay personal taxes, whatever dividends, or salary you pay yourself to then take the extra money, put it in the RESP. That loss of corporate tax deferral is really hard to make up for.
The one way that it does get made up for is by that grant. Taking enough money from your corporation to make sure that you put some money in the RESP, and get that CESG grant each year, which is 2500 bucks per year. That pretty much always comes out ahead, no questions asked. But if you start trying to finesse it beyond that, then it’s usually not worth it.
[1:09:49] BF: Because the grant is effectively reducing your personal tax rate on the withdrawal from the corporation.
[1:09:53] MS: Exactly.
[1:09:54] BF: Okay. So from a tax perspective, RESPs are similar to the TFSA in the sense that you’re contributing using after-tax personal dollars. Anyone can make that contribution. The money grows tax-free, with the exception of foreign withholding taxes. But then the growth is taxable when it’s withdrawn, and it’s taxable as income. That’s worth detailing a little bit maybe. If you have an investment that only earns capital gains, all of that capital gains will be taxed as income when it comes out of the RESP at withdrawal, but taxed in the hands of the beneficiary who hopefully has a low income.
Now, most investments accrue not only capital gains, so RESP is usually still pretty good bet. To use the benefits of the RESP, the money has to be withdrawn by the beneficiary or best be withdrawn when the beneficiary is enrolled in a qualifying training program. That’s going to include a university, college, trades programs, there’s a big list of stuff that is included in there, it’s pretty comprehensive. It’s been a while, but last time I looked at the list, there is some stuff where I was like, “It’s funny that’s on there. Those withdrawals are not all tax-free, though, as we’ve mentioned.
There’s three pots that you end up with inside of the RESP account. You’ve got your grants, the CESG, or [learning] bonds if you’ve earned those. Even growth, that’s investment returns on the grants, and the contributions, and then you’ve got your original capital that you’ve contributed. The grants and growth come out of the account as an educational assistance payment, an EAP.
The EAP are taxed in the hands of the beneficiary who is a student or in an educational program. There is a formula that’s used to determine the mix of grants and growth. It’s a proportional formula. So each time that you make an EAP, a taxable withdrawal, you’re removing a proportional amount of grant and growth. Hopefully, in practice, there’s not a lot of tax on an EAP, because the student has minimal other sources of income at that time.
There could be some tax if they have other sources of significant taxable income. But even still, if they have a summer job or something like that, and maybe they’re above the basic personal exemption, so they’re going to pay a little bit of tax on the EAP. It’s probably not a big deal. And it’s probably a lot better than taking that out taxable to yourself, plus a penalty, which we’ll talk about later.
[1:11:58] MS: Yes, exactly. But that’s the point I was going to make, because this comes up as a fear. But what if my kid does a co-op program, and they make actually a decent income doing their co-op? Well, for us as high-income professionals, it’s not just that they pay some tax, it’s that they’re going to still pay way less tax than we’re paying to access that money. So I wouldn’t get hung up on it.
[1:12:16] BF: The original money contributed comes out so your contributions come out as what’s called a PSE, a post-secondary education withdrawal, and those are tax-free. Because remember, that was your after-tax money that went in in the first place.
There are some common mistakes that I’ll mention. One example would be taking too much EAP in a year where the child has other income, because you can take out EAP and PSE, the taxable and non-taxable portions of the RESP can be removed from the account in a given year. If a child has for whatever reason, maybe they made a lot of money in their summer job, or they had a really good co-op semester or something like that. Maybe you don’t take out 100% EAP. In that year, you do a mix of EAP and PSE.
Now, on the flip side of that, there can also be an issue with not taking out enough EAP while they’re in school, which can result in taxable income to the subscriber, to the person who opened the account. Or because the EAP is always going to be a mix of grants and growth, if you end up with remaining EAP in the account, you can be in a situation where you’ve actually got to repay some of the government grants. There is a bit of strategy here, and there’s a bit of thinking that goes on to how to take money out of the RESP. It’s not crazy complicated, but there are definitely errors that people including financial advisors can make.
An RESP can remain open until the last beneficiary turns 34. If the money in the RESP is not used to fund post-secondary education, there are some implications. Now, they’re not that bad, and I’ll talk through them. But I do want to say. one of the most common reasons that I hear people not opening an RESP is that they’re worried their child is not going to go to post-secondary education. Now, remember, we said that the list of things that qualify is pretty broad, so that’s one thing to think about. But then the other thing to think about is what we’re about to cover, which is that the outcome is not that bad. It’s not like you’re losing all of your money, for example if they don’t go to a qualifying post-secondary education.
In that case, child never goes to a qualifying program, your contributions come back out tax-free. That was your money, you get it back. The government grants are repaid. So in the example with the corporation earlier, the government grants helped to make it make sense to take the money out of the corporation. In that case, if you’ve got to repay the grants, that ends up definitely being a bit of a downside, relative to how you made the decision. But even still, you got those grants for making contributions. If they don’t go to school, you’ve got to pay them back.
The access left in the account, which is going to include earnings on the contributions and on the grants, that can be transferred to your RESP if you have room available. If the beneficiary is disabled and qualifies for the disability tax credit, in that case, the RESP earnings can be rolled into an RDSP as long as certain conditions are met. We’ll talk more about the RDSP in a minute. If the RDSP is not available and there’s no RRSP room to put the EAP amounts, the grants go back to the government and the remaining growth comes out as an accumulated income payment. That is subject to tax at your tax rate, plus a 20% penalty to account for the fact that you had growth from the investment grants, and that you’re tax-sheltered for the time that it was growing.
[1:15:10] MS: I mean, there’s lots of different exit strategies that are available to you. I think the one that we probably should spend a bit of time on, though, as you’ve mentioned briefly was the RDSPs. So if you have a child that’s the beneficiary, that becomes apparent that they’re not going to be able to pursue post-secondary education of any kind off that big extensive list due to some severe mental disability. That’s a case where with some other conditions being met, you might be able to use an RDSP instead. It’s a bit more complicated, but it can be very, very important.
[1:15:39] BF: Honestly, we could do a whole episode in the RDSP, so I’m going to give super high-level commentary, but this is another one. Realistically, we could do a full episode on any one of these accounts.
[1:15:47] MS: Our episode is getting pretty long already.
[1:15:50] BF: Okay. The RDSP is less common. But in cases where it does apply, it’s really important. I’ve seen a lot of cases where people have family members who very likely qualify for the disability tax credit, or maybe even qualify for the disability tax credit, but have not opened an RDSP.
Like the RESP, the RDSP can receive bonds, and matching grants, and then eventual withdrawals from the account, or similarly, again, divided into taxable, and a non-taxable portion. RDSP grants depend heavily on household income. If the beneficiary’s household income is below $100,392 in 2023, a $500 contribution attracts a $1,500 matching grant. It’s pretty big matching red.
The maximum for lifetime grants is $70,000. Beneficiaries with incomes below $32,797 in 2023 can also receive $1,000 per year in the form of the bond of the Canada Disability Savings Bond, just for having the account open. So in that case, you don’t have to make contributions. And then the lifetime limit for the binds is $20,000. Grants in the RDSP need 10 years to vest. This means that if you make a contribution, and get a matching grant, the contribution has to remain in the account for 10 years to avoid needing to repay the grant on a withdrawal.
The RDSP can be funded up to age 49, and then the withdrawals are set to start after age 59, 10 years later. So you can see the timeframe, they’re set up to allow the final grants to mature. There are more complexities at the withdrawal stage of the RDSP. But because this is less common account, we’re going to leave it there for now.
One important note, actually. I learned this recently from someone who learned it the hard way, as they explained it to me, you can only have one RDSP account open at a time, that’s unique to the RDSP. But I spoke with someone who ended up having two accounts open and it caused all kinds of problems. Anyway, so don’t have more than one RDSP open at a time.
[1:17:37] MS: Well, so we’ve covered off a whole bunch of different registered accounts there. So they all have these different purposes, and they all have significant tax advantages. So with some limitations into them, but they’re all at advantageous in their own way. Now, the main limitation that’s ubiquitous across all of them is limited room. For most of us who are high-income Canadians of whatever it is that we do, we’re going to fill up those registered accounts pretty quickly once we start really putting our minds to investing, and saving, and investing for the future.
The reality is, that a lot of us, because we’ve started our careers later, or all of our other factors in our life, we have to actually still invest a lot more money beyond that. Which means we’re going to have to spill that money into non-registered accounts. So those taxable investment accounts. How that taxation works depends on whether it’s a personal account, or a corporate account, which works better is going to depend on your circumstances. There are times where households may have both personal and corporate taxable investment accounts. You may have a wide variety, in addition to all these registered accounts that we’ve talked about today. So, we are going to discuss how those personal accounts work, including a deep dive on the basics of investment taxation in the next episode. And then corporate investment taxation is a bit more complex, and we’ll cover that in its own dedicated episode as well.
[1:18:55] BF: I don’t know if you noticed this, Mark. I definitely do notice it. When people fill up their registered accounts, registered accounts are like these nice, well-defined little boxes. You have this much you can put in, there’s specific rules around how they work. I think people get that even though the accounts can be complex, people kind of get it. You put 2500 into your RESP, you put 6,500, whatever, there’s specific amounts. So, people fill those up, and then when they go from that to taxable investing, which is this big, open sea of unknowns, people get a little bit nervous.
[1:19:23] MS: This is definitely where people get hung up and they sit there on these large cash balances because they don’t want to invest it the wrong way. Which really, there probably isn’t a wrong way, as long as you heard all the other things we’ve talked about. The issue, I think, is once people start to pay some taxes, they want to make sure that they’re not paying more than what’s necessary, and they are afraid of making a misstep and that happening.
But really, I think actually the biggest risk that taxes pose is not actually the taxes. It’s that thinking and worrying about them deters us or delays us from investing our money in taxable accounts, and that’s the spot we got left. We should be using that. This brings me back to say that the tip of that portfolio pyramid is the taxes, it’s a tiny little impact at the top.
Time in the market is the base of that pyramid, and that time, along with diversification, and keeping your fees controlled, and suitable asset allocation – that makes a much bigger difference than finagling about any of these little tax issues. That said, I mean, taxes are still important. Part of why I’ve spent so much time writing about it is because, demystifying that I think actually defang some of the fear about investing in registered accounts, once you realize that it’s not that big of a deal. So, we’re going to wrap that up for this episode with a quick point about taxes, and asset allocation, because it does have an impact even within these registered accounts. They’re tax-sheltered.
[1:20:42] BF: Yes. I think this is a concept that’s quite commonly missed in general, including by professionals. I can even count myself as one of the people who got this wrong for a while, but I think it’s a very, very, surprisingly very common thing to get wrong. So the idea here is that the account type that you hold an asset in affects your exposure to that asset class, which affects your asset allocation. The worst offender for this concept is the RRSP, because remember, it holds pre-tax dollars. So you get the deduction for making a contribution, but the end effect is that the dollars in your RRSP account are pre-tax dollars.
So when you look at your brokerage account, and you see whatever, $100,000 in your RRSP, you think you have $100,000 in your RRSP, but you really have $100,000, less your future tax liability, which is whatever. Say it’s 50%, you really have $50,000, in your RRSP. Now, we start getting into tax optimization, which we’ll do a future episode on. But we start thinking about, is there a way to optimize my taxes by deciding which assets to hold and which account types. A common idea there historically has been, well, let’s put all the bonds in the RRSP account. Now, you can run a model, and I’ve run the model that proves that putting all of your bonds in your RRSP gives you the best-expected outcome.
But the reason it’s counterintuitive, and this is where it gets tricky. The reason that you would get a better-expected outcome from putting all of your bonds in RRSP is that it makes the portfolio more risky. Not that it improves your tax efficiency. The benefit of all bonds in the RRSP strategy comes from asset allocation, not increased tax efficiency. Because only the after-tax portion of your RRSP account matters to you. That’s what you own, the government owns the remainder.
So, you’ve got to remove the expected tax liability from the account to perform proper asset allocation. If you ignore that, and put all of your bonds in the RRSP and perform your asset allocation on the assumption that you own all of your RRSP account, what you’re effectively doing is reducing your after-tax exposure to bonds, or in other words, increasing your exposure to equities. So we’re going to revisit that concept when we get to the episode on tax optimization. But I think the main takeaway for people to think about is that you need to account for your after-tax asset allocation when you start thinking about tax optimization.
[1:22:49] MS: That’s right. Most of us don’t do that naturally. I’ve been ruined now because every time I look at my RRSP, I discount it, but that’s a recent phenomenon. And you have to actually account for that with your asset allocation. So we’ll get more into that another episode. I think we’ve effectively traversed the financial duodenum, and that’s the first part of the small intestine. I think we’ve even caught a few glimpses further down into the depths of the bowels of this topic, but we’re going to forge ahead in our next episode. First, we’ll regroup with a bit of a post-op debrief.
Okay. So in this episode, we reviewed the different account types that you can use to hold your investments in. You can open those accounts through your brokerage or advisor’s brokerage. Some institutions like banks may limit what you can put into the account, and it’s often their products, so it’s important to know that you have alternatives.
[1:23:37] BF: There are some rules about what you can hold no matter what institution is acting as the custodian. But for most of the asset classes that we care about, and most of the investment vehicles that we care about, like low-cost ETFs, and cash, and GICs, you’re going to be able to hold those at most brokerages. There are some rules when using registered accounts, but they offer tax advantages, and sometimes even grants, and other incentives.
[1:24:00] MS: Those registered accounts have different tax characteristics, and we’d have to consider those if we were trying to tax optimize our overall portfolio. But there’s two big concepts that we’ll revisit in the next episode as well. One is tax deferral and tax drag. Tax deferral affects how much capital you have to invest now. And then there’s the tax liability that’s baked into it when you have to access that money later on. For example, with the RESP, it’s 100% tax deductible now, but you’re going to have to pay the tax and you take the money out later. Tax drag is the drag on growth from taxes collected on investment income, and that tax drag affects how fast it’s going to grow moving forward. So tax deferral is how much money you have to invest upfront. Tax drag is the drag on growth. Even registered accounts can have a minor amount of tax drag from foreign taxes depending on the investments that are held there. So let’s summarize the main characteristics of the different account types.
[1:24:58] BF: All right. So the TFSA is funded using after-tax personal dollars. So there’s no tax deferral, but there’s also no Canadian tax drag. You could have some foreign withholding tax drag. All of the growth in the account is tax-free on the Canadian side, and you don’t lose space when you take money out. Or in other words, you’re able to make withdrawals without sacrificing your future room. The main limit on the TFSA is that it’s relatively small in size and contribution limit, and there are some rules impacting its usages, like you probably don’t want to be day trading in your TFSA. Otherwise, you might look like a business.
[1:25:34] MS: And you might lose your space permanently too. Lots of reasons. I think the RESP is similar to the TFSA in terms of its tax drag. There’s no Canadian tax on the income. There might be some foreign withholding tax, but there’s also no tax deferral. You can invest with after-tax money, but the new growth is going to be taxed. And then the income of your kids’ hands, or whoever the beneficiaries are, hopefully that’ll be at a low tax rate relative to you while they’re a student. Plus, to sweeten the pot, you also get grants along the way, so a guaranteed 20% return upfront on the first $2,500 each year for quite a number of years that you put into that account.
The main limiters are relatively low lifetime contribution limit, which is $50,000, and the need for the beneficiary to enroll in some type of post-secondary training, which can be fairly broad. Don’t fuss too much about trying to optimize the account, just make sure that you use it and take advantage of the grants and the timeframe. The largest impact is going to be from that and avoiding some excessive costs that you might experience in a group plan.
[1:26:37] BF: Yep, so that’s the RESP. The RRSP gives you 100% tax deferral on your contributions. You’re making contributions with pre-tax dollars. There’s no Canadian tax rate inside of the account that grows tax-free. There can be foreign withholding tax drag depending on where the investment is domiciled. US-listed equities are exempt from foreign withholding tax inside the RRSP. The contributions are limited in size based on your earned income, and that’s up to a maximum of new room each year. That was 171,000 in 2023. That will give you the maximum room. If your income’s higher than that, you don’t get additional RRSP room. You can use an RRSP for the homebuyer’s plan or Lifelong Learning Plan, which we didn’t talk too much about during the episode. But those are, for education, you can take some money out. In both cases, you’re effectively borrowing from yourself, and you’ve got to pay the money back over time. Eventually, you do have to take money out of the RRSP and pay taxes on it, usually by converting it to a RIF at age 71.
[1:27:33] MS: That brings us to the FHSA, which is the newborn housing-obsessed love child of a TFSA and an RRSP. It’s got 100% tax deferral like the RRSP does. There’s no tax drag except foreign withholding tax. And it’s essentially tax elimination, it comes out the other end like a TFSA with no tax if you’re using it to buy a first home. And if you aren’t going to use it for that, and you eventually have to close it out, you can pile it into your RRSP on top of your usual RRSP contributions. So this is a gift, but only if you can qualify. And make sure that if you do open one of these accounts, that you can make the regular contributions to avoid losing some of that unused contribution room.
[1:28:15] BF: All right. So in summary, the registered accounts are designed to have tax advantages, but they’re restricted by contribution room and sometimes by the way that the funds can be used, at least if you want to use them optimally. That means that you will generally want to take advantage of the registered accounts first, if you can before using taxable accounts. However, most high-income Canadians will have more money to invest beyond what they can fit in their registered accounts, and that’ll tend to happen pretty early on in the career of a professional. So for that, you end up having to use taxable accounts and we’re going to take the money scope out to examine the basics of taxable investing in the next episode. In the meantime, please join us for the case conference accompanying this episode on account types in Canada.
