Why Bonds Should Go in Your Non-registered Account

The conventional wisdom in much of the Canadian financial blogosphere is tilted to holding bonds in your RRSP. However, the logic behind this generalized advice is not as optimized as it should be for an investor who wants to maximize their after-tax wealth.

We know RRSP withdrawals are subject to full rate taxation. By standard financial planning, big RRSPs are a big problem, especially once you hit the age of 71 and mandatory withdrawals kick in (via RRIFs).

Large withdrawals can put you into high tax brackets, sometimes even higher than your working years. In the worst case scenario, they can reduce your seniors benefits such as OAS.

Bottom line, a high embedded tax liability can significantly reduce the real value of your RRSP, and thereby your true wealth.

Unlike RRSPs, TFSA growth is never taxed again, including withdrawals. There should be nothing holding back the investment growth in your TFSA account.

Bonds have historically provided lower returns than stocks. This has led some of the financial industry to promote placement of low growth assets—like bonds—in RRSPs. However, this only makes sense if you exclusively invest in a TFSA and RRSP.

Bond interest is taxed at full rates on top of your other income. For tax efficiency and investment return reasons, you generally want to avoid having lots of interest income in your non-registered investment account.

While I believe you should seek to limit inflexible taxable income at all times, it is especially when you are working and your interest income can be taxed at marginal rates of 40 percent or higher.

Since many of the most popular bond ETFs generate the vast majority of their returns via distributed interest income, high taxes on this interest can substantially reduce your true bond returns.

Bond Return Realities

If you take a closer look, bond returns are actually much more dynamic than the simple interest income, especially in managed or index bond ETFs.

Bonds not only generate interest income, they also return capital gains (which are taxed at a 50 percent inclusion rate) and return of capital (which is not taxed per se, but lowers your cost base).

This means bond ETF distributions and overall bond ETF returns can be much more tax efficient than you think.

Thanks to financial innovations, bond ETF structures have evolved to become increasingly tax efficient. Every self-directed investor today has access to low cost bond funds which have these tax efficient features.

In Canada we have swap-based bond ETFs which are super efficient, essentially converting all returns to deferred capital gains.

We also have a discount bond ETF which invests in bonds discounted from their face value. This reduces interest income and increases capital gains (both distributed and deferred).

Further down, we will look at bond returns for several popular ETFs including XBB.TO (a standard bond index ETF), ZDB.TO (a discount bond ETF), and HBB.TO (a swap-based bond ETF).

RRSP Structure vs Non-registered Account Structure

To understand the effects of taxes on this bond allocation question, it is important to review the tax implications of RRSPs compared to non-registered accounts.

RRSPs

RRSPs are first and foremost a tax deferral account. While you make RRSP contributions with "before-tax" money (you claim the contribution amount on your income tax return to reduce your taxable income), you pay full income taxes on RRSP withdrawals.

Apples for apples, after the tax break at your highest marginal tax rates, you can contribute more to your RRSP than any other self-directed account.

Example

If you are in the 40 percent tax bracket and you have $10,000 cash to contribute to an account, you will actually be able to gross up your RRSP contribution to $16,666 after factoring in the $6,666 you will get back on your tax return the following spring. If you don't have the extra $6,666 to contribute, you can borrow it from your bank via a short-term loan and pay them back once you get your tax refund.

Moose Tip!  Plan ahead and complete a T1213 form with the CRA to reduce the taxes withheld from your paycheque.

A second large advantage to RRSPs is you pay no taxes on any investment income or gains held within your RRSP account. You only get taxed when you actually withdraw money from your RRSP.

You can buy and sell securities, realize profits, collect dividends and interest income and pay no tax. RRSPs can be a good place to engage in active, higher return investment strategies as there is no tax drag on your returns.

Finally, RRSPs are recognized as a retirement account with many of Canada's tax treaty partners. The tax treaty arrangements mean that any distribution income from U.S. listed ETFs or stocks will not be subject to U.S. withholding taxes (saving you 30 percent tax on the distribution amount).

Non-registered Investment Accounts

A non-registered investment account has far fewer benefits which translates to lower contributions and lower returns.

You cannot deduct contributions to these accounts from your income at tax time. Depending on your tax bracket, this effectively reduces your true contribution amount by 30 percent to 50 percent compared to your RRSP.

Also, you must pay taxes on any realized income each year. This includes dividends, realized capital gains, return of capital, and interest income. Certain forms of income such as capital gains and Canadian dividends are taxed at lower rates, while capital losses can be used to offset gains.

The tax costs of constantly having to claim this income each year is called the tax drag. In an efficiently invested account, the tax drag will often be 0.5 percent of your account value. In a poorly managed account it can be much higher.

Example

In the same 40 percent tax bracket you can only contribute the $10,000 you have in your hands. This means right off the bat, your non-registered account balance is more than one-third smaller than your RRSP would be. If you realize dividend income during the year, it will be taxed at approximately 25 percent, reducing your investment returns. If you realize some capital gains (profits) on the sale of an asset in any year, you must include half of the profit to be taxed. This would translate to an effective tax rate of around 20 percent on the profit portion at this income level.

Broad Bond ETF Comparisons

Here are the actual bond returns for three popular bond ETFs with very different tax structures. We used the 2014 to 2018 time period as many bond ETFs are still quite new to the Canadian market.

The indices these ETFs follow are also somewhat different, so part of the difference in the returns is due to the particular index being tracked. For example, XBB.TO holds 35 percent federal government bonds while HBB.TO holds 42 percent federal bonds.

Source: TheRichMoose.com

Taking a quick look at this chart, you can see that the simplest bond ETF (XBB.TO) has the largest overall pre-tax gain. This is not surprising since ETFs which engage in more transactions or have more complex structures naturally will have somewhat higher fees and management costs.

It should be noted that the management fees have compressed in ZDB.TO and HBB.TO. The return differential between these ETFs and a standard bond ETF is likely to shrink further in the future. Going forward the return difference between XBB.TO and HBB.TO is likely to be under 15 basis points.

We know that, if you only have a RRSP and TFSA account, the RRSP is the better of these two options in which to hold your bond allocation.

Moose Tip!  If you hold bonds in your RRSP, choose the cheapest, simplest bond ETFs (XBB.TO, VAB.TO, ZAG.TO, etc.). The interest income will not be taxed.

Tax Comparisons for Non-registered Accounts

Lets take a look at tax liability for these funds should you hold them in a non-registered account, assuming the investor is in the 40 percent tax bracket.

To keep the numbers simple, we'll assume that the bond holding started at $100,000 in May 2014 and you are selling your holding in June 2018.

Source: TheRichMoose.com

Despite the higher pre-tax return of the simple bond funds, the tax advantaged bond ETFs are a much better choice once taxes are factored in.

The swap-based bond ETF (HBB.TO) outperformed the simple bond index ETF by 25 percent over four years purely due to the compounding effects of tax drag on realized income.

Bonds are for Non-registered Accounts

Given the benefits of tax efficient bond ETFs, it is suddenly very feasible to hold your bonds in your non-registered accounts. After adjusting for tax drag, return metrics, and some other factors, bonds should be held in your non-registered account for maximum post-tax wealth gain.

Since most Canadians will only ever invest in TFSAs and RRSPs, the average Canadian investor with a conventional buy-and-hold portfolio will have their bonds in their RRSP. Of these two registered accounts, it is definitely preferable to put bonds in the RRSP over the TFSA. TFSAs are for unbridled growth assets, not slow growing bonds.

But many Canadians who are aggressively building wealth, myself included, invest a substantial portion of their assets in a non-registered account. Once the TFSA and RRSP accounts are full, non-registered investment accounts are the remaining option for investing in the publicly traded markets.

If you have a RRSP, TFSA, and non-registered investment account, your non-registered account is the best place for your bond ETFs.

This is particularly true if you invest in HBB.TO, the highly tax efficient swap-based ETF from Horizons. Here is the math to demonstrate why:

Source: TheRichMoose.com

Dealing With the Large RRSP Issue

Despite common financial wisdom cautioning investors about big RRSPs, an aggressive and savvy investor should make it their goal to maximize the value of all their accounts including their RRSPs.

While a truly massive RRSP is not necessarily an easy thing to deal with from a tax perspective, don't be fooled into thinking you will automatically be stuck with a large tax bill that is so damaging you should have avoided large returns within your RRSP.

You can withdraw money from your RRSP and still be tax efficient. With some planning, you should be able to get money out of your RRSP nearly tax free.

The issue of RRSP size/tax liability is actually something I've changed my own mind on as I have learned more about aggressive (and still legal) tax planning.

For example, an aggressive tax planner can use several tactics to reduce their taxes on RRSP withdrawals in retirement. The main strategy would be creating interest expenses to offset your income.

The most aggressive way to do this is using your RRSP to borrow against your house for investing purposes. You may be able to withdraw tens of thousands each year from your RRSP completely tax free while technically remaining debt-free.

If you are open to taking on debt, you can take out a home equity loan for investing (like the end of the Smith Manoeuvre process) or invest with margin in your non-registered investment account.

You can also reduce taxes on your investment profits in your non-registered account by strategically harvesting capital gains to increase the adjusted cost base of your investments. This strategy can help you pay no taxes at all on your swap-based bond ETF, even when selling ETF units for a profit.

Don't be fooled by conventional planning tax fears. More money in your RRSP gives you more options. Better tax planning increases your overall net wealth. For these reasons, use your RRSP to buy growth assets like stocks (particularly foreign listed stocks) and worry about the tax issues on withdrawals later. Put your bonds in your non-registered investment account, but make sure you buy one of the more tax efficient bond ETFs to increase the true returns your bonds can provide.

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.

Taxation of Assets in Non-registered Accounts

In Canada our taxation system sets different tax rates for several major forms of income. With the exception of property taxes on real estate, we don't have an asset tax or wealth tax. Taxes on assets are actually charged on the income or capital gains derived from those assets in each year that income is realized.

For investors, it is important to note that we have several account-based options available to us for investing. Each account works differently and offers different tax advantages and disadvantages. In the past I have covered taxation and strategies on registered accounts such as the TFSA and RRSP.

Reduce Taxes on RRSP Withdrawals in Retirement

Proper Ways to Use RRSPs

RRSPs for Huge Tax Savings When Retiring Early

TFSA vs. RRSP vs. Non-registered Account

Now lets take a look at non-registered investment accounts (also the investment account that will be used for the Smith Manoeuvre) and how investment income is affected by taxes within this standard brokerage account.

Non-registered Investment Accounts

A non-registered investment account can go by many names depending on your brokerage. It is a standard brokerage account with no special tax treatment. Some of the names I have seen used by Canadian brokerage firms for non-registered accounts include:

  • Joint investment account
  • Individual investment account
  • Regular investor account
  • Standard investment account
  • Margin account
  • Cash account

In a non-registered investment account, any income received and all capital gains realized in a given tax year must be declared on your income tax return. This even includes interest earned on your personal chequing or savings account.This is one of the primary differences when comparing to RRSPs and TFSAs where income and realized capital gains held in the account are not reported or subject to taxation.

If you have a non-registered investment account at an online brokerage, your brokerage will typically upload a couple tax forms onto your account every spring following the end of the last tax year. These forms may include a T5 Statement of Investment Income, a T3 Statement of Trust Income, and a T5008 Statement of Securities Transactions. Each of these forms provides information that you must declare to Canada Revenue Agency on your income tax returns.

Different forms of income are taxed at different rates in Canada. There are three broad categories of income which apply to investments: Other Income, Capital Gains, and Canadian eligible dividends.

Other Income

Other Income is taxed at the highest rates of the three forms of income discussed here. Other Income includes employment income, business income, foreign income (including foreign dividends), and interest income. All these forms of income are added on top of any employment or pension income and are taxed at standard marginal tax rates for your province.

Interest Income

Interest income is the most common form of Other Income related to investments. It is often derived from bonds, GICs, or bond ETF holdings. However, it is also seen buried in distributions from REITs and real estate ETFs.

As a high tax form of income, interest income should be reduced as much as possible in non-registered investment accounts. If you need to invest in bonds in a non-registered account, choose a tax efficient bond option. This could include using a swap-based ETF such as HBB.TO which converts all interest returns to embedded capital gains behind the scenes. You could also invest in discount coupon or strip bond ETF such as ZDB.TO or BXF.TO which tries to tilt some of the bond returns to capital gains rather than interest.

Foreign Income

Foreign income is another common form of investment income which is taxed as Other Income. Foreign income is most often realized by holding foreign-listed stocks, bonds, or ETFs directly, or buying a Canadian-listed ETF which invests in foreign stocks, bonds, or ETFs for you.

The actual foreign income is the dividends or interest distributed to you by these foreign assets. Foreign income is taxed at two levels. First, before you even get the money in your brokerage account, the foreign government where the company resides taxes the distribution by way of a withholding tax that usually is in the range of 15% of the total distribution amount. Then, the remaining 85% (or so) is taxed as foreign income by the Canadian government. The foreign withholding tax cannot be avoided, except for certain countries when the foreign asset is directly held in an RRSP; however, when the investment is in a non-registered account you can claim the tax paid back on your income tax return.

Many investors misunderstand withholding tax and income tax on foreign income. To simplify, don't shy away from diversifying internationally just because of these taxes. That said, try be as tax efficient as possible by not choosing high dividend or high interest foreign investments. Aim for ETFs or stocks which pay a dividend yield of 2% or less. This caps your tax drag to approximately 0.3% per year on the withholding tax and, depending on your income level and province, around 0.5% to 0.7% on the income tax. The total tax penalty of 1% or less is still worth the diversification benefits that international investing provides.

Capital Gains Income

Capital gains income is taxed at a very preferential tax rate and has several other important advantages. First, capital gains are only taxed when you actually realize the gain. That is when you sell some or all of an investment that has gone up in value. As long as you don't sell, you are not taxed on the gain. Second, capital gains can be realized strategically to increase your cost base, which in turn reduces your future deferred taxes. Additional purchases of the same investment also increases your cost base. Finally, capital gains are taxed the same regardless of where the investment is from. This means a capital gain on a stock investment in a Canadian company is taxed at the exact same rate in the exact same manner as a capital gain on a U.S. stock or ETF investing in foreign markets.

When you do sell an investment which has gone up in value, just 50% of the profits from the sale are taxed. This is called the inclusion rate. For example, if you purchased $50,000 worth of one ETF and after ten years that position has grown in value to $100,000, when you sell you only pay taxes on $25,000. [($100,000 - $50,000)*0.5]. This means your total tax bill on a $50,000 profit would be no more than $13,500 even in the highest taxed provinces at the highest income levels.

Since an investment portfolio tilted to capital gains provides a lot of flexibility and super-low tax rates, you should often choose investment growth over investment income. Control over realizing capital gains and the limitless deferral of those gains can allow substantial compounding, tax-free wealth over long periods of time.

Canadian Eligible Dividends

Dividends paid to investors by Canadian publicly-listed companies are taxed at very preferential tax rates thanks to the dividend tax credit. The dividend tax credit is a mechanism which credits back to the investor an amount approximately equal to the corporate tax rate which the company already paid. This prevents a form of double taxation (corporate income tax plus personal income tax on the dividend).

These low tax dividends can be realized if you buy Canadian-listed companies directly on the stock exchange, or if you buy ETFs which hold a portfolio of Canadian companies.

The personal tax rates on these dividends for the investor can be very low--even negative at low income levels in some provinces. Negative tax rates can help you offset income taxes on other forms of income. If your income consists of Canadian eligible dividends only, you can effective earn nearly $50,000 of dividend income and pay zero income taxes in many provinces (B.C., Alberta, Saskatchewan, Ontario, New Brunswick, and Prince Edward Island).

However, there's a catch. Dividend income gets grossed up by 38% on your tax return before the dividend tax credit is applied. This means $50,000 in dividend income actually looks like a $69,000 income. Be careful about earning a large amount of dividend income because it could impact your benefits including Child Benefits, OAS benefits, and GIS benefits among other provincial social security benefits resulting in much higher true tax rates than you think.

Summary

You will almost always being paying some income taxes when you have investments in a non-registered investment account. However, a portfolio tilted towards capital gains and Canadian eligible dividend income will still be highly tax efficient due to low tax rates on these forms of income.

If you are very efficient in your investment strategy in a non-registered account, you can expect taxes to reduce your investment returns by approximately 0.5% per year. That relatively small cost is well worth the diversification, flexibility, and investment benefits that broadly diversified portfolios in non-registered investment accounts can provide.

Generally speaking, non-registered investment accounts are not the best place to engage in frequent buying and selling, investing in bonds or GICs, or investing in high dividend foreign stocks or ETFs. These strategies or assets can be impacted by much higher tax drags and meaningfully reduce your overall returns.

Read my tax allocation article and list of favourite ETFs to get some ideas of what to put in your non-registered investment accounts to remain tax efficient.

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.