Thursday, September 29, 2011

Should I keep my investments in Registered Accounts?

I get asked this question alot from friends and family.

Should you keep your investments in Registered accounts like TFSA or RRSP?

In a word, most often, YES.

Do you make more then the Personal Tax Exception (~$10000) anually?
If so, then you can make some use of the tax-avoiding plans and accounts that the Canadian Government has made available to you.

If you simply purchase company stock certificates, and hold them personally, without any broker, it's just you and the tax-man. All gains (capital gains or distributions) will be taxed directly, and you will have no choice or recourse. You will always be taxed twice (when you earn the money as income, then taxes on your gains and dividends).

In a TFSA, you use income taxed money, but all gains in the 'account' are not taxed. This means you are taxed once (when you earn the money as income).

In a RRSP, you use non-taxed money to contribute, then all gains in the 'account' are not taxed. You are taxed when you retrieve the money from the 'account'. You are only taxed once (when you withdraw the money from the account).

In both types of registered accounts, you avoid double-taxation. This is almost always a good thing. To have equities (stocks, bonds, etc) in a registered account you need a broker.

Okay now that we have some background, Lets crunch some numbers!

Non-Registered Account Example

Purchase of Telus (T) stock certificates:  $5000
Annual Dividend Yield 4.2%
Annual Dividend $210
Dividend Taxes (40-80k tax bracket) ~ $28 (13%)
Capital Gains Taxes (40-80k tax bracket)  ~ 11%

Notice that the taxes paid on dividends are taking in to account the 'Dividend Tax Credit', which means that most Canadian company's dividends are not taxed at marginal rates (AKA normal income tax rates). But note that they are adjusted by a gross-up (38% in this example) for taxation purposes, as per the chart shown here for 2012. This means even though they are taxed at a lesser rate, the income is taxed as if it is 38% more then it actually is.

So, while we don't get taxed anywhere near the normal ~22% marginal rate for the 40-80k tax bracket, we still get taxed. Remember that we are paying tax on our income (income tax), and also on the gains that are derived from that income (the dividend). This is essentially double-taxation.

I dislike being taxed, so I am strongly against the idea of being taxed twice.

Also, notice that we will be paying the tax on the dividend every year that we hold this investment.

There is no relief from double-taxation in non-registered accounts.

Now, lets look at that same investment if we put it in a TFSA.

TFSA Account Example

Purchase of Telus (T) stock                      $5000
Annual Dividend Yield 4.2%
Annual Dividend $210
Dividends Taxes (Any Tax Bracket) 0%

So, in a TFSA, which allows a annual contribution of at least $5000, we do not pay tax on our Canadian dividends or capital gains. The USA does not recognize the TFSA as a 'retirement' type of account so you will see large withholding tax penalties on US dividends & gains, which make it a bad idea to hold US assets in a TFSA.

If you wish to take the money out of a TFSA, you do not get back your contribution room until the next year, that is January 1st.

If you are saving away for something medium-term, this makes an ideal place to do it. If you're looking at some place to save for the long-term then you want to look at RRSPs.

RRSP Account Example

Purchase of Telus (T) stock                     $5000
Annual Dividend Yield 4.2%
Annual Dividend $210
Dividends Taxes (Any Tax Bracket) 0%

In an RRSP, you do not pay tax on any dividends or capital gains from Canadian or USA sources. For USA sources, you do not pay withholding taxes either, making it a good place to put USA equities.

Any funds put in a RRSP are tax-differed, so you do not pay tax on the contribution for the year that the contribution is claimed. So investing in an RRSP is a great way to avoid paying taxes in the higher tax brackets.

The flip side of this is that you do pay taxes when you withdraw any amount from a RRSP, and you are penalized an additional percentage if you withdraw before you officially retire.

This means that you must plan much further ahead with the RRSP - You will not be able to withdraw the money without penalties except for a few, specific situations (Home Buyers Plan & Lifelong Learning Plan).

When you take money out of an RRSP you do not get back your contribution room. Ever.

I hope this helps clear up some of the confusion about where to invest your hard-earned cash.

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