TFSA vs RRSP vs Non-Registered? What is the right account for your investments?

When Canada introduced the TFSA into the mix of registered and non-registered investment accounts, it made an already difficult decision even harder. How do I allocate my investments between my TFSA, RRSP and non-registered accounts? We’ve prepared a number of examples below to help investors understand the tax treatment of different investment types and the optimal account mix for their portfolio.

Growth Stocks

Growth stocks are stocks that are primarily held for capital gain purposes (stocks where you hope the future value increases, not stocks that you hold for dividends). These stocks should be held in either the TFSA or a non-registered account. This is because capital gains are taxed more favourably in Canada than regular income, at 50% of the effective rate on regular income. Generating capital gains in an RRSP actually results in more taxes being paid. Here is an example of a stock held for a year in each account, assuming a tax rate of 30% (remember that capital gains are taxed at ½ your effective rate):

As you can see, the TFSA slightly outperforms the non-registered account as no tax is paid on the capital gain in the TFSA. The RRSP does not significantly outperform the non-registered account due to the favourable tax treatment of capital gains.

There is an important note, however. What is interesting is that most Canadians do not reinvest the tax savings generated by RRSP contributions. Most Canadians spend them. In fact, in some cases Canadians are earning negative effective after tax returns on their RRSPs due to the eventual tax loss in their RRSP because if this. When this is done, a taxpayer is effectively borrowing tax savings today and forcing themselves to repay it when they retire, and are much less likely to be able to afford it. An important consideration for sure!

It is also important to note that any capital losses in a non-registered account can be applied back three years against capital gains, or applied to any future capital gains indefinitely. This is not true with the TFSA or RRSP, where losses have no tax benefit.

Dividend Stocks

Dividend stocks have favourable tax treatment in comparison to regular income as well, but not quite as favourable as capital gains. Let’s assume: we invest in a stock with a 10% dividend, no capital gains, a 30% general income tax rate, and a 20% tax rate on dividends. Here again we see the advantage of the TFSA, followed by the RRSP which is even more preferable than the non-registered account in the case of dividends because dividends are taxed at a higher rate than capital gains.

The Impact of Compounding

Now the results for RRSPs don’t look as favourable as some would have expected in the previous two examples, but that is not the total story. Remember, in our examples, we only looked at one year returns. RRSP’s are not for short term investing, but rather retirement savings, and the intention is that investments are held for long periods of time. When dealing with compounding investments, an RRSP has an advantage as the initial investment is higher and therefore benefits from additional compounding over time. Further, there is no tax being taken out of the account in each period, allowing further growth. Here is another example of a dividend stock, but this time, we hold the stock for ten years:

*Note: in this example, I provided the total tax amount for the non-registered account… however, this would have been paid out in each of the years this investment was held, not at the end (I have accounted for the compounding correctly). I have also assumed the $9 “tax credit on the reinvested tax credit” is realised in year one, which is imperfect, but does not impact the results of this simple illustration.

Notice that now the TFSA has a substantial advantage over the non-registered account. This is because each year the non-registered account must pay tax on the dividends, and that cash cannot be used to further investment. However, with the TFSA, no tax is paid and that additional cash can be reinvested. Also, in this example, the RRSP outpaces the non-registered account, due to the benefit of the compounding of the saved taxes. Never the less, the TFSA remains the most favourable option.

Bonds, Term Deposits and GICs

Bonds are one asset class where RRSP’s have the edge over non-registered accounts in all scenarios, and especially when holding bonds over long periods of time. The TFSA will still hold an edge, but since interest is taxed the same as regular income, there is no tax advantage to holding bonds in a non-registered account.

This is also true for any term deposits or GIC’s that one may own. These are also best held in a TFSA account. It is not recommended to hold investments you may need access to in the short term in an RRSP due to the difficulty and cost of making withdrawals.

Summary

As we’ve seen above, there are a number of considerations when allocating your investments to your various accounts. To benefit from optimal tax efficiency, for an investor with a balanced portfolio, all fixed income assets should be held first in a TFSA until your contribution limits are met, and then in an RRSP. Equity investments can also be held in an RRSP if they are being held over the long term, but any short term holdings (especially as one nears retirement) may be more appropriately invested in a TFSA or non-registered account.

If you have maxed out your RRSP contribution limits and TFSA limits, ensure that interest bearing investments are in the RRSP and TFSA accounts and any dividend or capital gain investments are in the TFSA or non-registered account.

At the end of the day, the TFSA is always the most tax efficient account. Max it out first. Then analyse your investment classes based on the examples above to determine the best allocation for the strategy and types of investment you are planning to hold!

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