Depending on which brokerage you end up choosing, when you create your investment account, you will be faced with a crucial decision: determining which tax type you will use to gain access to investing. In this blog post, we will take a look at non-registered, TFSA, and RRSP accounts. These are 3 popular account types in Canada, and depending on which you are eligible for and choose, your choice will determine your fate once tax season rolls around. Although there are more account types out there, it’s common for beginners to use one of these three as a starting point in Canada.
Overview: Registered vs Non-registered
After choosing your brokerage, you’ll be greeted with a choice between registered and non-registered account types. First and foremost, I want to clarify that TFSAs and RRSPs fall under the registered category of account types. This means their activity is reportable to the Canada Revenue Agency (CRA) and there are some benefits as well as limitations to their taxation and contribution amounts, respectively. Contrary to registered accounts, the non-registered account type comes without CRA restrictions when it comes to contribution limits but also don’t see the same kind of tax breaks.
In this post, we will shed some light on the pros and cons of both account categories while highlighting tax impacts and the contribution limits of the different account types.
The non-registered account type is a generic account option available for investors on any brokerage platform. Also known as cash or open accounts, because of the lack of CRA reporting involved in their administration, offering this account type requires substantially less paperwork than any of the registered plan types and is no doubt the easiest to open.
However, non-registered accounts are considered to lack the tax benefits that attract many Canadians to registered plans. If you receive dividends or income in a non-registered account, you will have to declare the full amount on your income tax return with no deference, keeping in mind you may qualify for the federal dividend tax credit if you’ve received dividends from Canadian corporations. A bit easier to swallow is the concept of capital gains. If you sell securities in your non-registered account, you will only be taxed on 50% of the money you made at your marginal tax rate. If you experience a capital loss, you will be able to cancel the 50% amount against any gains for that year, the previous 3 years, or carry the loss forward indefinitely as long as you file it in the year it occurred.
For those who determine that a non-registered plan is the best fit for their financial goals, they may be attracted to opening a marginal account. This type of non-registered account allows you to borrow money from your brokerage to invest as opposed to a regular cash account that allows you to buy securities using the funding you provided. Of course, with this lending comes interest but an increased amount of buying power that could be worth it if the market swings in your favor.
TFSA - Tax-Free Savings Account
The Tax-Free Savings Account, or TFSA, is a tax-advantaged account type available for Canadian residents over the age of 18. Withdrawals from a TFSA are tax-free along with any dividends or distributions earned in the account. Note: the tax exemption for dividends and distributions is limited to Canadian listings. For example, dividends from US-listed equities may still be subject to a 15% foreign withholding tax when they enter your account.
An important thing to know about TFSAs that keeps it from being too good to be true is that investors are limited to a contribution room. From the year in which a Canadian resident turns 18 or the year in which someone becomes a Canadian resident, TFSA contribution room entitlements begin to accumulate. The yearly contribution limit started at $5,000 in 2009 when the account was introduced. From there, it is indexed to inflation and rounded to the nearest $500 (with the exception of 2015 when it was increased to $10,000 by the Conservatives, then brought back down to $5,500 the following year when the Liberals introduced their budget). Since 2019, the contribution limit has been $6000 and will remain so until inflation pushes it to $6,500, or legislation changes.
To keep contributors in line, the CRA receives a file from every TFSA administrator each year with a report of TFSA transactions for all investor accounts. Therefore, there is no need to report anything related to a TFSA on an individual basis, but the taxman will find out if you’ve abused the program and any overcontributions will trigger a penalty charge of 1% per month. If you have a CRA account online, you can always check your yearly contribution room on their website.
As mentioned, TFSA withdrawals are not taxable but are still important to track as the amount redeemed in one year will be added to the contribution room of the following year. For example, if you withdrew $1000 from your TFSA in 2019, $7000 in total will be added to your accumulating amount in 2020 ($1,000 recovery + the $6,000 2020 amount). If you weren’t maxed out in 2019 already and you had $20,000 of contribution room let to carry forward on December 31st, 2019, your new contribution limit would then be $27,000 in 2020.
A final note on TFSAs for anyone considering investing in Real Estate Investment Trusts (REITs): Because of the fact that distributions are earned tax-free, TFSAs may be preferred for holding Canadian REITs rather than in an open account as distributions aren’t eligible for the federal dividend tax credit mentioned previously due to their tax structure.
RRSP - Registered Retirement Savings Plan
The Registered Retirement Savings Plan (RRSP) is another tax-advantaged registered plan that allows you to grow your savings tax-free but unlike TFSAs, you will eventually get taxed on the amounts within the account. What makes RRSPs attractive for many Canadians is the fact that you can deduct the amount you contribute to your account from your income tax. However, there are contribution limits to doing this, but they are more likely to vary from individual to individual than TFSA limits. Comparable to the TFSA, overcontribution may result in penalties and additional charges.
To be eligible to open an RRSP, a Canadian resident must have earned income in the previous calendar year. This is because your RRSP contribution room is based on your income in the previous year. It will be 18% of your previous years' income up to a maximum of $27,230 (2020), indexed annually. Like the TFSA, this contribution room accumulates and carries forward if it is not used. To help you wrap your head around this, consider the following examples:
Bob earns $100,000 in 2019. He has never contributed to an RRSP and was provided with the contribution limit of $50,000 by the CRA for 2019 given his previous years' amounts that have been accumulating. In 2020, he decides it’s time to open an RRSP. The most he will be able to contribute to his RRSP is $68,000 (this is the $50,000 he has been accumulating all along with + 18% of his income for the previous calendar year).
Everything remains the same as above except Bob earns $200,000 in 2019. The most he will be able to contribute to his RRSP in 2020 is $77,230 (this is the $50,000 he has been accumulating all along with + $27,230 since 18% of his income for the previous calendar year was greater than this limit).
When it comes to withdrawals from an RRSP, the full amount withdrawn will be taxed as income regardless of your age. You can technically redeem from an RRSP at any time, but redeeming while you are in your higher-earning years will defeat the purpose of contributing and deducting the amount from your income. The plan is most effective from a taxation perspective when you are reducing your income when you’re subject to higher tax rates and redeeming when you are in a lower tax bracket (i.e. in retirement).
There are also programs available that allow you to borrow from your RRSP on a tax-deferred basis. The Home Buyers Plan (HBP) allows you to redeem up to $35,000 from your RRSP to purchase or build a qualifying home providing you contribute the amount back to an RRSP in your name on a regular basis over the course of 15 years (generally 1/15th of the full amount you withdrew, starting the second year after you withdraw the funds under the HBP program). Repaying your HBP will have no impact on your contribution room but if you miss a payment, you will need to declare the amount you missed as income for the year you missed it. There is also a similar program called the Lifelong Learning Plan (LLP) for which you can redeem for education purposes.
Finally, when it comes to choosing investments to hold in your RRSP, you may consider holding US-listed equities in this account over a non-registered or TFSA if there are investments of this nature you are interested in purchasing. This is because dividends received are not subject to the US foreign withholding tax under the RRSP umbrella.
Which account type did you choose to get started? Personally, I first started investing through a Margin account with Questrade. Shortly after, I added a TFSA when I established my contribution room after moving to Canada and then opened an RRSP the year after I started working here. For me, maxing out the contribution room of the tax-advantaged accounts takes priority when planning my contributions.
As a new investor, what content would you like to see me cover in this series? Comment below!