When we map out a placement plan for which investments will go into which accounts, there are many principles that we factor into our recommendations. We do not duplicate holdings across accounts for several reasons, one of which is to ensure that each client has their portfolio structured in the most tax-efficient manner. Below are The Greenard Group’s six principles of placement for investments between registered and non-registered accounts:
1) U.S. stocks that are primarily growth, or have zero to low dividends, may primarily be held in a non-registered account.
Any returns generated will be tax-efficient capital gains. Two examples of growth stocks would be Alphabet (formerly Google) and Amazon. Alphabet and Amazon both pay zero dividends.
2) Stocks that have a higher level of fluctuation and risk should generally be held in a non-registered account.
Losses in a non-registered account can be offset against capital gains and any unused net capital losses can be carried back up to three years or carried forward indefinitely.
Beta is a measure of a stock’s volatility in relation to the volatility of the market as a whole. The market as a whole has a beta of 1.0. Stocks with a beta of less than 1.0 are considered less risky than the market as a whole. Stocks with a beta greater than 1.0 are considered riskier than the overall market.
Higher beta holdings should be primarily held in a non-registered account. Alphabet has a beta of 1.10 and Amazon has a beta of 1.05 — both are more volatile than the general market.
3) U.S. stocks that pay medium to higher dividends may be held in a Registered Retirement Savings Plan (RRSP) or Registered Retirement Income Fund (RRIF).
Procter & Gamble pays a dividend of 2.50 per cent. PepsiCo Inc. pays a dividend of 2.78 per cent (dividend yields are per Thomson One as of June 6, 2022). The Convention between Canada and the U.S. was negotiated to ensure that double taxation does not incur on certain types of income. As a result, the U.S. does not withhold any tax on U.S. dividends or interest within RRSP or RRIF accounts.
4) U.S. stocks that have a lower level of fluctuation and risk would generally be held in a registered account.
Procter & Gamble has a beta of 0.75 and PepsiCo Inc. has a beta of 0.84 — both have lower risk than the market.
5) Canadian equities with returns from the growth in share price and/or dividends, for the most part, would be held in a non-registered account when possible.
This is because only 50 per cent of gains on the sale of the appreciated shares are taxable and the dividend distributions are eligible for the dividend tax credit.
6) Depending on your risk appetite, holding medium-risk blue-chip Canadian equities within a Tax-Free Savings Account may be right for you.
The U.S. does not recognize Tax-Free Savings Accounts (TFSA) as a tax savings vehicle for Canadians, and as a result, a 30 per cent withholding tax is applied on U.S. dividends, unless the Canada-U.S. tax treaty reduced rate of 15 per cent is applicable — this is an absolute cost that cannot be claimed or recovered.
We always caution clients to not be too conservative with the TFSA as you will not be able to utilize the true benefits of tax-free growth. On the flip side, we also caution clients not to be too aggressive with the TFSA as losses cannot be claimed as it is a registered account.
The above placement of investments assumes that an investor has both non-registered and registered investments. Periodically, it is a good idea to take a step back to see if all investments are placed to optimize the tax characteristics of each type of income.
Income splitting and other tax considerations also are important to factor in when mapping out what types of investments to put into the different types of accounts. In many cases, we are able to identify opportunities for tax efficiencies by shifting investments around for new clients that may result in significant tax savings.
The foundation that makes up The Greenard Group’s six principles of placement has to do with how the four different types of investment income are taxed, and the difference in what ends up in your pocket depending on whether you are realizing capital gains, or earning Canadian dividend and interest income, or foreign investment income.
By thoughtfully structuring your investments and taking care which holdings you place between accounts, you may end up with more in your pocket after-tax. This is why we carefully map out a placement plan for our clients between their registered and non-registered investment accounts.
Registered accounts include Registered Retirement Savings Plans (RRSP), Registered Retirement Income Funds (RRIF), Locked-In Retirement Accounts (LIRA), and Tax-Free Savings Accounts (TFSA). All income and growth within an RRSP, RRIF, and LIRA is tax-deferred until withdrawals are made. For RRSPs, RRIFs, and LIRAs, tax only applies when amounts are withdrawn from these accounts. For TFSAs, there are no tax consequences when amounts are withdrawn from these accounts.
To illustrate, a client may have contributed $350,000 to an RRSP over 20 years with annual cash contributions (20 years x $17,500 per year). Within this period, the account has grown to $1,250,000. The $900,000 in accumulated growth could be attributed to capital gains, U.S. dividends, Canadian dividends, and interest income.
The nature and types of income do not matter within both RRSP and RRIF accounts. Any amounts the client takes out of these accounts are fully taxed, dollar for dollar, in the year of withdrawal.
Let’s assume a client wishes to pull out $50,000 gross every year for cash flow. If $50,000 was pulled out of a RRSP or a RRIF, an income tax slip would be issued after the end of the year to the client for the full gross amount of the withdrawal, including tax withheld. The income must be reported on the client’s tax return.
If we assume the client is in the highest tax bracket (53.50 per cent tax bracket in B.C.), the amount of tax payable is approximately $26,750 ($50,000 x 53.5 per cent).
Withdrawing your capital from a non-registered account is not taxable, as the funds are already after-tax dollars. Let’s look at how $50,000 of investment income would be taxed in a non-registered account for this same high-tax individual. The types of investment income are U.S. dividends, Canadian dividends, interest income, and capital gains.
Both U.S. dividends and interest income are fully taxable, with no tax-preferred treatment. If an individual’s income was comprised of only U.S. dividends and interest income, then the amount of tax payable would be the same as a withdrawal from a registered plan, or $26,750 (as illustrated above).
On the other hand, if the $50,000 was purely capital gains, then only 50 per cent would be taxed, or $25,000, resulting in a tax payable amount of only $13,375 ($50,000 x 50 per cent inclusion rate x 53.5 per cent tax).
Canadian dividends are eligible for the dividend tax credit if held in a non-registered account. Canadian dividends are first grossed up, and then a tax credit is applied. In essence, the 2022 top effective tax rate for clients earning eligible dividend income in a non-registered account is 36.5427 per cent.
If a client receives $50,000 of dividends the amount of tax payable is $18,271. In conclusion, both Canadian eligible dividends and capital gains result in less tax than both interest income and foreign dividends.
Lower tax bracket in the future
The concept of pulling RRSP investments out when you are in a lower tax bracket works if you have not accumulated a lot of wealth within your account during your lifetime. Our goal is to help clients continually build their wealth.
Being in a lower tax bracket while in retirement isn’t always the goal or realistic for affluent clients. We are finding that our affluent clients are accumulating more wealth even as they age which corresponds to higher levels of income, even in retirement.
Deferral and unrealized gains
There may be a consideration of losing tax preferential income when investing in registered accounts. To illustrate, we will use Bill, who purchased 3,000 shares at $25 per share of a Canadian bank stock twenty years ago. The total original book cost was $75,000 (3,000 x $25) and was purchased within a non-registered account. At the same time, Jane purchased 3,000 shares of the same Canadian bank stock for $75,000 but within her RRSP account. For purposes of this article, we will ignore the tax savings Jane received for the initial contribution.
Today the shares are valued at $85 per share for a current market value of $255,000 ($85 x 3,000).
As a comparison, Bill has had to pay tax on the quarterly dividends that the bank has paid him on an annual basis while Jane hasn’t as the income is tax-deferred within her RRSP account. Over the last 20 years, neither Bill nor Jane has had to pay any tax on the appreciated capital gain on the share price.
If Bill ultimately sells the shares in his non-registered account, 50 per cent of the $180,000 capital gain ($255,000 - $75,000) would be taxed, or $90,000 ($180,000 x 50 per cent inclusion rate). If Bill is in the 53.5 per cent tax bracket, he will pay $48,150 in taxes for selling the bank shares ($90,000 x 53.5 per cent).
Let’s assume that Jane also decides to sell and deregister the proceeds of $255,000 from selling the bank shares. Above, I mentioned that every dollar is taxed in RRSP or RRIF withdrawals. If Jane is also in the top tax bracket when the funds are withdrawn, then $255,000 is included in her taxable income and the amount of income tax she will have to pay is $136,425 ($255,000 x 53.5 per cent).
Foreign interest and dividends
We discuss with clients how foreign interest and dividends are fully taxed with no tax-preferred treatment, even if held within a non-registered account. The exception to this is the Convention between Canada and the U.S. where negotiations took place to ensure that there is no double taxation on certain types of investment income. The end result is that no tax is withheld at source on U.S. dividend or interest income within RRSP or RRIF accounts.
Canadian interest income
As there is no preferred tax treatment, this type of investment has historically been held within an RRSP. The challenge that many people battle with by putting all interest-bearing investments within registered accounts is the lack of overall growth. Interest rates have been at historic lows, and now that interest rates are rising, this is a negative for fixed income which does not provide the same overall long-term rate of return as equities.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email firstname.lastname@example.org or visit greenardgroup.com.