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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Investing With Student Loan Money

Something that gets brought up on occasion by more money-savvy students is the idea of getting a student loan and using the money to invest. While this certainly looks good on paper--get money for free and invest your way to riches--I think it's often driven by stories of a few students who get these loans, invest the money in very risky investments, make a lot of money on those investments thanks to a healthy dose of luck, and then brag about their success to their friends. I also suspect most of these investing savants have reasonably wealthy parents who will bail them out if need be.

You should always skeptical of these outrageous success stories. Most successful traders who actually know what they're doing tend to be very humble about their success. If a trader understands risk, they know that massive returns can be followed with equally large drawdowns. Doing this all with borrowed money is dangerous. When a boastful trader gets wiped out by taking on too much risk, you can bet they'll either lie about their success to continue enjoying the attention it brings, or they'll suddenly get very, very quiet about their investments.

It's also interesting how the story of the guy who made tens of thousands or more in investing profits with their student loan money tends to proliferate around bubbles. Right now its the whole crypto thing, pot stocks, and micro-cap lithium miners. When I was in university it was small-cap energy stocks and the BRICs. The collapses that followed prove once again that seemingly easy money is never truly free. Investing is a great humbler.

All this said, lets take a look at how student loans work and why they might actually be a great way to get some arbitrage advantage and make relatively easy money with minimal risk.

Student Loan Structure

Student loans from government sources are a subsidized loan based on the need of the student. "Need" tends to be a bit of a grey word in this world. In your application, you are required to declare many types of government income assistance (except the Child Benefit), funding from parents (including RESP money), and income from investments you hold. Other forms of income and assets sometimes don't need to be included in your application, but that might vary depending on your province.

Government student loans are typically the loans you want to invest with. They normally do not accrue interest while you are enrolled in full-time studies so its essentially free money during this time. Between federal and provincial loans, you can get a substantial amount of money adding up to thousands dollars per semester in a Bachelor's program. You can get even more for professional programs such as medicine or law.

There's also a large category of private sector student lines of credit from the banks. These loans accrue interest right away and often you must pay the interest costs while you are still in school. This often means borrowing more money to pay interest costs. You want compound interest working for you, not against you, so these loans should be avoided. The interest rates on these loans are also quite high making them much more profitable for the banks than for you.

A very important thing to remember with student loans is that you cannot declare bankruptcy to escape the burden of repaying your loans. While loan forgiveness exists, it is only be applied in very particular circumstances and it depends on who provided the loan (federal sources, provincial sources, or private banks).

Governments and the big banks have a lot of power and they can make your life pretty miserable when it comes to getting their money back. For these reasons, student loans are no joke. Graduating with big student loans you can't immediately pay back and going into a mediocre job with all that debt can really damage your financial opportunities for a long time.

Using Student Loans to Invest

To invest your student loan money, you clearly need to have income or money sitting somewhere else to actually pay for your education. This gets tricky because you are required to declare a lot of your income, including help from parents. However, you are often not required to disclose your personal savings or certain forms of income such as tips. I suspect a lot of people getting student loans for investing purposes are not being truthful on their applications; lying is never a healthy path to take in life.

However, lets assume you can legally obtain student loan money and you don't need it to pay for living expenses or education costs. What should you do to maximize your opportunities and how should you invest?

Tax Issues

When you are a student, your income is probably low enough that you won't pay any income tax. That said, the best place to put the money you want to invest is still in a TFSA account. You can open a self-directed, online TFSA account in about 20 minutes with Questrade--an easy brokerage to learn investing. You are able to open and fund a TFSA when you turn 18. The current contribution limit is $5,500 per year, but that amount is cumulative. Always check your TFSA contribution limit using CRA's My Account before funding your TFSA account to avoid over-contribution penalties.

TFSAs are great because the money you make within the account is completely tax-free. You can also withdraw the money very easily when you graduate to pay back your loan. You don't need to report the withdrawals as income on your tax return and any gains you made are reflected in your future contribution limits.

For people who begin to work a reasonably well-paid job after graduation, you might not want to pay off your student loan by withdrawing money from your TFSA. Student loan interest on government loans is tax-deductible from your income so it can be a form of "good debt" when used properly. From a tax efficiency perspective, you would be better off to keep those investments in your TFSA account growing while slowly paying the minimum required on your student loans from your working income. If your TFSA is worth $30,000 when you graduate at age 23 and you continue to invest $5,500 per year earning 6% returns for the next 35 years, your TFSA will grow to nearly $900,000 by the time you are in your late fifties.

Invest Cautiously

Although you might not want to quickly pay off your student loans when your graduate, you still want to have that option if need be. Not everyone gets a job right away after graduation and most recent graduates don't immediately obtain high-paying jobs.

When you invest with borrowed money--regardless of the source--you should invest very carefully. Capital preservation is of ultimate importance! Your ability to make up losses is probably quite limited, so you do not want to lose a lot of money with this approach.

The goal should be to make a bit of money while ensuring you can pay back your loan immediately when you graduate without any problems. This means your investment timeline is actually quite short, maybe somewhere between four and seven years depending on your program. Your investing strategy should be designed with small potential drawdowns which are recoverable in a short time. This is very different from investing for retirement with a 40-year time frame.

You should also remember that your goal is not to take a big swing and try hit the ball out of the park. Singles and doubles will do. Your hurdle rate is extremely low (0% interest while in school), so invest with that in mind. Every dollar you make with another person's money is a dollar you wouldn't otherwise have! If you can make a 4-5% return on free borrowed money with very little stress and work involved, you are doing very well.

Viable Investment Strategies to Consider

As I stated, you should not swing for the fences when investing your student loan money. This is not money for Bitcoin investing, pot stocks, or micro-cap mining stocks. I would strongly suggest you stay away from any shady investment forums or newsletters. For every loud winner in that world, there are 100 silent losers.

Let's take a look at some reasonable example strategies, including an estimated account value if you invest $5,500 at the start and contribute another $5,500 per year for four years using average returns for each strategy. Remember, all investing means taking on risk so don't start if you can't afford to lose money.

1. An easy option would be investing in a single ETF that has plenty of downside protection. Right now, the Vanguard Conservative ETF portfolio (trades as VCNS.TO) is a pretty good option. It has 60% bonds and 40% stocks, all diversified globally, within that one ETF. The fees are low and the underlying strategy is simple. It would have made annual returns of nearly 6% over the past 20 years with a maximum 12-month drawdown of less than 12.5%.
Estimated TFSA ending value of $30,940.

2. You could also invest in a simple, diversified bond ETF such as XBB.TO. Annual returns since 2001 would have been approximately 4.75% with a maximum drawdown of just 4.2%. Bonds tend to be very stable, so this is a great way to get a reasonable return while taking great caution to limit your downside.
Estimated TFSA ending value of $30,240.

3. You could also invest in a barbell-type strategy with two ETFs. Again, downside protection is very important so don't get too aggressive. If you want to keep things simple and limit yourself to Canadian-listed ETFs, you could invest 75% of the portfolio in short-term bonds such as XSB.TO. The remaining 25% of your portfolio can be invested in a leveraged ETF such as HQU.TO. You should re-balance this portfolio once per year to keep the risk down. In the past 20 years, your returns would have been around 10% annually with a maximum 12-month drawdown over 15%.
Estimated TFSA ending value of $33,575.

Summary

Using student loan money for investing is not as straightforward and easy as many promote it to be. You should never lie to get money, especially when it comes from the government or the big banks. Fraudulent loan applications are criminal offences and you can pay with your freedom for that. Nevermind trying to get a good job, or credit, with a fraud conviction on your record.

Student loans are stuck with you for life until you pay them off. You can't declare bankruptcy or default on the loans. Whenever you invest using borrowed money, you should be very cautious. You want to have the ability to pay the loan back when needed without any issues.

The best place to invest your student loan money is inside a self-directed TFSA account. Most people would be best off purchasing ETFs and investing very conservatively. This includes investing in diversified bonds, a conservative portfolio ETF, or a conservative barbell strategy with a large portion of short-term bonds. These are just a few simple examples of how to invest with caution in mind. There is always an element of risk when it comes to investing. If you are not able to stomach that risk, or if being unable to pay off your student loan would cause you serious harm once you are graduated, you should not be investing that money. Period.

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.