TFSA or RRSP or Non-registered Investment Account

In Canada investors and savers have three primary accounts in which they can place money for retirement. All these accounts will allow you to invest in a wide range of financial securities. The most common securities include bonds, publicly traded stocks, mutual funds, ETFs, and publicly traded REITs both domestic and foreign listed.

The biggest difference between these accounts is how they impact your personal tax situation. Taxes, unfortunately, can become very complex even at the individual level. This unnecessary complexity is why all these special tax treatment accounts, like the RRSP and TFSA, have been created.

Read this post to get an understanding of investing and investment taxation across different accounts.

The complexity of these special accounts have given a distinct advantage to people who hire professionals to assist them with their finances (generally the wealthy crowd), or Canadians who have taken the time to understand the implications of each account on their wider tax and benefit situation.

Lets discuss the differences between these accounts and which accounts you should choose for your situation.

TFSA

Tax Free Savings Accounts are available to every Canadian over 18 years old. The annual contribution is capped at $5,500 (in 2018), but the contribution room amount is cumulative if you don't put money in your TFSA. You contribute to a TFSA with after-tax money, but you don't pay any taxes on withdrawals. Any investment returns made within the account, including dividends and realized capital gains, are not taxed.

Under the current system, you don't even need to report withdrawals from your TFSA account on your income tax forms. This means, if all your income is from a TFSA, you could appear to have ZERO income and maximize your benefits in retirement--including benefits designed for very low income seniors such as the Guaranteed Income Supplement (GIS).

RRSP/RRIF

Registered Retirement Savings Plan is a tax-deferral account available to every Canadian who files taxes. The annual contribution limit is equal to 18% of your earned income up to a maximum contribution increase of $26,230 (in 2018); unused RRSP room is cumulative and can be carried forward. You get a tax refund for RRSP contributions at your highest marginal tax rate, but you must pay full income taxes on withdrawals from RRSP accounts. Realized income kept within the RRSP account are not subject to tax until withdrawals are made.

Once RRSPs are converted to a RRIF (Registered Retirement Income Fund), any withdrawals you make are eligible for the Pension Income tax benefits and can be split with your spouse. RRSPs must be converted to a RRIF when you turn 71. RRIFs have mandatory withdrawals which are based on your age and the value of the account. The minimum withdrawal rate increases as you get older. You may not make any contributions to a RRIF account.

You can make withdrawals from a RRSP account when you are working, but the withdrawals will be added to your other income and be taxed at full tax rates. However, you can "borrow" money tax-free from your RRSP using the Lifelong Learning Plan (LLP) or Home Buyers Plan (HBP). You are required to "pay back" your RRSP when using these special plans. If you don't make those payments, the minimum required repayment for that year is added to your income and taxed as if it were a RRSP withdrawal.

Non-registered Investment Accounts

These are standard investment accounts which receive no special tax sheltering or deferral treatment. There are no limits on how much money you can contribute to a non-registered investment account, which makes them the default choice once contributions to registered accounts have been maxed.

Taxes on certain types of investment income--Canadian dividends and capital gains--are lower than taxes on employment income. You must pay taxes on any gains you realized during each tax year which reduces your net investment returns. Due to the lower realized investment returns after taxes, registered accounts (RRSP/TFSA) are often preferable to non-registered accounts. You can make your non-registered accounts more tax efficient by investing in products that do not generate income and where capital gains can be deferred for long periods of time. Swap-based index ETFs are a good example of this.

Low Income Comparison ($40,000)

Source: TheRichMoose.com

When you are in a lower income situation, you will find minimal differences between the accounts. From a pure income tax view, the RRSP with reinvestment of the tax refund is the best choice, just slightly beating out the TFSA. That's because you would slightly benefit from the difference between the highest tax rate on contributions and a lower blended tax rate on withdrawals. This small difference is mostly due to the basic personal deduction. Non-registered accounts do quite well for low income individuals because the tax rates on realized gains within the account along the way do not significantly impact returns and can actually reduce your overall tax bill in certain situations.

Middle Income Comparison ($70,000)

Source: TheRichMoose.com

If you are in a middle income situation, you will find the RRSP account with reinvestment of the tax refund to begin pulling away from the other options. The spread between tax refunds on the RRSP contribution and taxes owing on the RRSP withdrawals to increase. Even with relatively careful investing, the actual return on investments after taxes in the non-registered account will begin to suffer more.

High Income Comparison ($120,000)

Source: TheRichMoose.com

If you are a higher income individual, RRSP accounts should be your first priority. The spread in tax refunds on RRSP contributions and taxes owing on RRSP withdrawals continues to grow. Also, you must be very careful how you manage any investments in your non-registered investment accounts because the taxes on realized income there get quite punitive! Again, the TFSA is always a reasonable option that performs well.

It's Not This Simple

If you take a quick look at these charts, you might assume it is always best to invest in your RRSP first--as long as you reinvest your tax refund. While the RRSP is certainly a decent choice regardless of your income, the way our system of tax credits and other social benefits are designed makes it much more complex.

The real answer of the best account for you depends not just on your gross income, but also on your spending and total savings rates. For example, a reasonable person earning $120,000 should be saving much more than $5,500. You should save at least 10% of your gross income if you start young, expect a reasonable retirement, and will have a paid-off house by the time you retire in addition to your investments.

An individual saving $12,000 per year returning 6% over a forty-year period will see their account grow to nearly $2 million. You can't invest $12,000 per year in a TFSA, so you will be forced to save in your RRSP from that perspective. However, if your RRSP is worth $2 million at retirement, your tax rate on $80,000 of RRSP withdrawals will be quite high (22.09%). You will also get benefit clawbacks at this level of income.

RRSP accounts are also less flexible than TFSA or non-registered accounts. When you turn 71, your RRSP must be converted to a RRIF and you must make mandatory withdrawals from the account at a rate that climbs higher every year--even if you don't need the money. Since RRSP withdrawals are taxed similar to employment income, they are more difficult to access during your working years as well.

When RRSPs Should Be Prioritized

Although there are numerous complexities involved and it's never very straightforward, you should consider making the RRSP your first priority if you:

  • Are more educated in financial planning and are serious about reducing income taxes
  • Will always invest the tax refund back into your RRSP
  • Have a moderate to very-high income when you are working (over $50,000)
  • Don't spend a lot of money relative to your income
  • Plan to retire early so you can reduce your RRSP before it must become a RRIF
  • Have a very small amount of money to contribute and want to maximize your total investment value
  • Make sure your RRSP account doesn't get too big so you can keep your withdrawals to a minimum
  • Invest in a more active style, often realizing gains
  • Will not make any withdrawals for any reason while you are working
  • Might use advanced strategies to reduce taxes on withdrawals (borrow to invest strategies)
  • Will go back to pursue full-time education as an adult
  • Are buying a house in the future after not owning a home for four years
  • Plan to take a sabbatical or otherwise reduce your income substantially before retirement
  • Have an uneven income with very high years and low years (self-employed in resource sector)

When TFSAs Should Be Prioritized

TFSA accounts are newer, but they offer many advantages that RRSPs don't. You should consider making the TFSA the first account to invest in if you:

  • Value maximum flexibility in investments, contributions, and withdrawals
  • Want a tax efficient option that performs well in all income and spending situations
  • Believe you might make withdrawals while you are working for any reason
  • Are likely to spend as much, or more money in retirement than when you are working
  • Think your retirement will include large, but in-frequent expenses (travel, new vehicles, etc.)
  • Anticipate moving from a low tax province while working to a high tax province in retirement
  • Are already contributing to a pension plan that will pay a large benefit in retirement
  • Would like to maximize government benefits as a senior (OAS, GIS, Pharmacare, etc.)
  • Invest in a more active style, often realizing gains

When Non-registered Accounts Should Be Prioritized

In general, non-registered accounts are the account of last resort. This means you have contributed everything you can to RRSP and TFSA accounts. However, there are some exceptions and you should invest in a non-registered account first if you:

  • Have a rapidly rising income and will transfer to a RRSP later to maximize your tax refund
  • Invest in a Canadian dividend strategy, have a low income, and live in a low-tax province
  • Are low income and borrow money from a high income spouse (spousal loan)
  • Borrowed to invest in a tax-efficient way and use the interest expense to offset other income
  • Borrowed to invest so that you can maximize your net worth
  • Want to access a wider range of investments without restrictions
  • Are a very active investor who might be considered a "trading business" by the CRA

Mixing Account Contributions

Particularly for higher income individuals with high savings rates, the best strategy is likely to spread contributions across several accounts. Start with aggressive contributions to your RRSP to get large tax refund. Then you will use the refund money and any other savings to maximize your TFSA account contributions. Finally, whatever is left will go into a non-registered investment account. This is the strategy I employ.

I am targeting a sizeable, but not enormous RRSP account. A target valuation of somewhere around $1 million is probably as high as I want to go. This means I will either stop contributing to my RRSP, or significantly reduce contributions to my RRSP as I reach this value. If I can keep RRSP withdrawals under $40,000 a year per person and top up the rest of my income with TFSA withdrawals or dividends from my non-registered account I will be happy. I will also use interest costs to reduce my taxable income from RRSP withdrawals.

Summary

In Canada the typical saver and investor can save for the future in three different account types: the TFSA, RRSP, and Non-registered investment account. The TFSA and RRSP exist to provide savers with distinct tax advantages. TFSA are "tax-free" after your contribution; RRSPs are actually a tax-deferral mechanism, but you save on taxes by getting tax refunds at a high marginal tax rate but pay taxes on withdrawals at a lower blended tax rate after tax credits and deductions.

While TFSA contributions are not tax-deductible, you can invest in your account without being taxed on investment income and you can withdraw money from your TFSA without paying tax on your withdrawal or even claiming it on your income tax return.

You deduct RRSP contributions from your income, so you get a tax refund which should always be invested. You don't pay taxes on any investment income within your RRSP account until you make a withdrawal. RRSP withdrawals are taxed like regular income and you must report withdrawals on your income tax return. When you are retired, you would normally convert your RRSP to a RRIF so withdrawals can be treated as Pension Income for tax purposes. RRSP accounts are more intricate, not very flexible, but offer several embedded programs for earlier withdrawals. RRSPs are the ultimate account for tax arbitrage if you have a good understanding of the tax system.

Non-registered accounts are normally used after you have already contributed the maximum amounts to your RRSP and TFSA. Investment income from this account is taxed, but at preferential rates for Canadian dividends and capital gains on profitable trades. Non-registered accounts might be used first by individuals who are highly active traders, borrow money to invest, or are waiting until they are higher income before moving their investments to a RRSP. High income individuals should avoid realizing investment income in non-registered accounts.

Generally speaking, the RRSP can be the best account for investing even if you are lower income due to tax arbitrage. However, they are somewhat restrictive and require a reasonably good understanding of income taxes and Canada's social benefit system to get the maximum benefit. The average person is probably best off investing in a TFSA because the flexibility is unparalleled and it performs well in nearly all scenarios.

Side Note: I'm on vacation, so my posts next week will be put up a few days late.

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Importance of Personal Money Management

Managing your personal finances is likely the most important determinant of whether or not you become wealthy. It's certainly more important than some factors that many Canadians focus on: great investing skills, having a high income, or buying a house as fast as possible to start "building equity".

It might be a symptom of our immediate satisfaction culture, or it might be bad guidance and examples shown by adults from the time we are very young. But the millions of Canadians who bumble along from paycheque to paycheque scraping together a few nickels and dimes here and there for extra expenses are largely victims of their own bad decisions.

We're different here on TRM, so lets state the obvious of why control of spending is extremely important and give you some tips on how to manage your spending while still having fun and dealing with those larger expenses like vacations or home maintenance.

Saving Money is the Foundation

To become wealthy, you must save money. That's really all there is to it; it is the foundation on which everything else is built. It is completely impossible to build your net worth if your spending exceeds your income for any extended period of time. Only once you have accumulated some savings, can you begin putting money to work for you in a more passive manner. Build wealth from your wealth.

Save Your Way to Wealth

I like to save money first. This means putting a healthy portion of every paycheque directly in my investment accounts. Start by filling up your TFSA, your RRSP (unless you have very low income), and finally your non-registered investment account. If you are a couple who works together for a secure financial future, just filling your TFSA accounts is an easy fail-proof way to accumulate significant wealth over time that's completely tax free. If you want to get a bit more technical and tax optimize, you can mix your savings between TFSA and RRSP accounts.

It doesn't take special investing knowledge to grow $500 or $1,000 a month in savings into serious wealth by standard retirement age. With the Vanguard Portfolio ETFs, a simple one-ETF solution that mixes stocks and bonds with three different styles depending on your risk tolerance, you can achieve investment returns of 6% annually over time. For a couple who saves $900 per month, that grows to $1.3 million if you save from the time you're thirty until you are sixty-five. $1.3 million in investments is no joke! That will generate you a safe annual income of $50,000 to $60,000 per year, every year, for the rest of your life.

If you learn a lot about investing and achieve higher returns, you may hit your net worth goals much sooner and you could become very wealthy. However, that doesn't replace saving. Always save a lot and count on moderate returns. Then let those big returns go to work for you, powered by a big savings rate.

Use Monthly Moving Averages to Manage Expenses

To save money successfully and sustainably, you must limit your spending. To help get a better grasp of your spending and savings rates, you should average your monthly income, spending, and savings over several months. This is similar to using a moving average to determine price trends in investing. By smoothing your spending and saving, you can see the impacts over time, make better decisions, and reduce the big swings in spending that can frustrate you.

I believe a very good Rule of Thumb is making sure your Spending does not exceed your Net Income minus Savings over any rolling 6-month time period. This allows some planning for vacations, dining and entertainment, and other extras that shouldn't fit into your regular expenses.

Example:

John and June are a married couple who earn a combined $6,000 a month after their taxes and payroll deductions. Their goal is to save 15% of their take-home income every month ($900). Their reoccurring expenses include their mortgage payment ($1,800), property tax ($250), insurance ($300), cell phones ($150), cable ($100), vehicle payment ($400), electric and gas ($300), fuel ($250), and groceries and household supplies for a family of four ($800). This leaves them with $1,650 per month for savings and "extras".

The family is planning a vacation in July, which they do once per year. How much should they spend on that vacation?

Well, we know they want to save $900 per month in their investment accounts. That leaves $750 per month for things like vacations, emergency funds, and entertainment. Over a year, that adds up to $9,000. Smoothed out over 6 months, the family can spend $4,500 on these extras. Since its not wise to spend all of the $4,500 on vacation alone--dining and entertainment is important as well--they might decide to spend $3,000 on their vacation. We'll assume in a regular month, John and June will spend $200 on eating out and other extras, but in December they spend $1,000 to pay for gifts, visiting family, and some fun days.

To help smooth the cost, they could pay for the hotel costs in March ($1,200). Then in May they might start setting aside money in a savings account every month for the remaining vacation spending ($1,800). From this money, they will pay for restaurants, passes for entertainment parks, kayak rentals, or whatever else is on their list of things to do. If they decide to splurge when on vacation, they might decide to stop eating out while at home in May, June, and August to put all that extra money towards their vacation. The family can limit their spending to $50 per month on extras when they are "living on a tight budget".

By thinking about their spending taking into account past months and future months, John and June's spending never exceeds their income over a 6 month period of time. They can average their costs and still keep their spending under control while enjoying their vacation.

Here's how their income compares to their 6-month average spending over a two year period with the $3,000 vacation happening in the second year.

Source: TheRichMoose.com

While the monthly expenses (including their $900 savings) exceeded their income in several of the months, when averaged over 6 months, they never had their expenses exceed their income. It always had a cushion ranging from $100 to $450 dollars. This money could be used for entertainment and to fund their emergency accounts. This type of responsible spending makes sure your finances can withstand those expenses that pop up from time to time without diving deeper into debt.

You can quickly make a graph similar to this to keep track of your own monthly income, savings, and expenses with a simple moving average by using Google Sheets or Excel.

Be Careful with Large Asset Purchases

When it comes to income and expense smoothing, you should exclude large one-time asset purchases from your spending. This might include buying a house, or doing a large renovation. It is very easy to over-reach when buying these big assets because their costs, from a cash flow perspective, are broken into relatively small monthly payments. However, these monthly payments can make huge dents in your savings rates. My wife and I chose to go down to one vehicle and rent a smaller rowhouse for exactly this reason. Maxing our free cash flow lets us save over $60,000 per year!

Houses, when purchased at reasonable valuations, typically hold their value roughly in line with inflation over long periods of time. This has been clearly demonstrated with academic research. But you shouldn't be buying if it doesn't make financial sense. Grit your teeth and rent, or move somewhere house prices are more reasonable. Buying overpriced houses will make you poor.

Renovations are a bit tricky to value. The research I've done on this--from back when I was a carpenter and bought and upgraded my own house--suggests you are lucky to add around 75% of your renovation costs in increased value to your home for a typical, frugal renovation. This varies from 90% or higher for simple things like insulation, paint, doors, and mouldings to barely 50% for bathroom or outdoor deck upgrades. Generally speaking, high-end upgrades have a lower return on investment. DIY renovations can increase that return, but only if your work is of professional quality! So, if you do a $10,000 bathroom renovation and upgrade, you can expect your house to increase just $5,000 in value.

To some extent you might exclude vehicles and RVs as well, but you should always buy vehicles with a huge dose of caution. Along with over-priced housing, vehicles are a major source of financial problems. They depreciate rapidly and are expensive to keep on the road.

It's also tricky to conceptualize the true cost of a vehicle when most purchases are financed. Monthly payments of a few hundred bucks can appear a lot more reasonable than cutting a cheque for $30,000 to the dealership. I think it's better to buy used vehicles with cash that you've saved up over time. You can often find good used vehicles just a few years old for half of the new sticker price.

Summary

Everything on this blog, and in your personal financial well-being, starts with saving. You need to cut your spending, manage those large expenses, and maintain a consistent surplus over any 6-month periods to put money into those investment accounts. After all, there's absolutely no point in reading about investment strategies and how to maximize your returns while reducing your risk if you've got nothing to invest in the first place.

Investing on its own will never replace the need to save. You should count on obtaining investment returns of approximately 6% per year if you are willing to take on quite a bit of risk. Anything higher than that is a bonus. The difference between investing and obtaining 6% returns and obtaining 12% returns is the difference between becoming rich or super-rich. That's completely different from trying to invest your way to success because you are unwilling to save enough money. Saving the right amount of money first is essential.

Use a spreadsheet application such as Excel or Google Sheets to keep track of your monthly income and expenses. You can keep separate columns for each expense category such as mortgage, groceries, clothing, utilities, and savings. A simple averaging formula can help you track those bigger expenses and make sure you are not in a perpetual deficit spending situation. You also might be amazed at how much money you spend on useless stuff that provides you with no real value.

Watch those large asset purchases. Houses, vehicles, renovations, RVs, boats, and other big purchases should be analyzed very carefully. Nearly everywhere in Canada right now you are better off renting than you are buying a house. Keep in mind that renovations are not as good for your bottom line as they are often promoted to be. Vehicles and toys should be bought used with cash so you don't fall for those monthly payment traps. Monthly payments cut deep into your ability to save money.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.