All income and growth within Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) are tax deferred. Tax will only apply when amounts are withdrawn from these accounts.
To illustrate, a client may have contributed $300,000 to an RRSP over 20 years with annual cash contributions (20 years x $15,000 per year). Within this period, the account has grown to $1,000,000. The $700,000 in accumulated growth could be attributed to U.S. dividends, Canadian dividends, interest income, and capital gains. The nature and types of income does 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 $60,000 gross every year for cash flow. If $60,000 was pulled out of an RRSP or an RRIF, a T4RSP or T4RIF, respectively, would be issued to the client for the full gross amount and must be reported on the client’s tax return. If we assume the client is in the highest tax bracket (49.8 per cent tax bracket in B.C.). The amount of tax payable is approximately $29,880.
Spending your own capital in a non-registered account is not taxable, as the funds are after tax dollars. Let us look at how $60,000 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 US dividends and interest income are fully taxable, with no tax preferred treatment. If an individual’s income was comprised of only US dividends and interest income, then the amount of tax payable would be the same as a withdrawal from a registered plan or $29,880 (as illustrated above).
On the other hand, if the $60,000 was purely capital gains then only 50 per cent would be taxed, or $30,000, resulting in a tax payable amount of only $14,940. 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 applied. In essence, the 2019 top effective tax rate for clients earning eligible dividend income in a non-registered account is 31.44 per cent. If a client receives $60,000 of dividends the amount of tax payable is $18,864. 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 wealth and the concept of being in a lower tax bracket in retirement isn’t always the goal or realistic for wealthier clients. We are finding that our wealthier clients are accumulating more wealth even as they age which corresponds with 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 Jack, who purchased 2,000 shares at $15/share of a Canadian bank stock twenty years ago. The total original book cost was $30,000 and were held within a non-registered account. At the same time, Jill purchased 2,000 shares of the same Canadian bank stock at $30,000 but within her RRSP account. For purposes of this article we will ignore the tax savings Jill received for the initial contribution. Today the shares are valued at $45 per share. As a comparison, Jack has had to pay tax on the quarterly dividends that the bank has paid him on an annual basis while Jill doesn’t as the income are tax-deferred within an RRSP account. Over the last twenty years, neither Jack nor Jill has had to pay any tax on the appreciated capital gain on the share price. If Jack ultimately sells the shares in a non-registered account, 50 per cent of the $60,000 capital gains ($90,000-$30,000) would be taxed, or $30,000. If Jack is in the 49.8 per cent tax bracket he will pay $14,940 in taxes for selling the bank shares. Let’s assume that Jill also decides to sell and deregister the proceeds from selling the bank shares. Up above I mentioned that every dollar is taxed in RRSP or RRIF withdrawals. If Jill is also in the top tax bracket when the funds are withdrawn then $90,000 is included in her taxable income and the amount of income tax she will have to pay is $44,820.
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.
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 returns. Interest rates are low and fixed income options do not provide the same overall long term rate of return as equities.
Placement of investments within accounts
If we were to map out a placement plan for different investments in the various types of accounts, the following are a few general guidelines:
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 carry forward indefinitely. 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 higher risk. Higher beta holdings should be primarily held in a non-registered account. Alphabet has a beta of 1.15 and Amazon has a beta of 1.26 — both riskier than the general market.
3) U.S. stocks that pay medium to higher dividends may be held in a registered account. Procter & Gamble pays a dividend of 2.58 per cent. Johnson & Johnson pays a dividend of 2.82 per cent (dividend yields are per Thomson One as of July 15, 2019). The Convention between Canada and the U.S. was negotiated to ensure that the double taxation does not incur on certain types of income. As a result, the US 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 0.73 and Johnson & Johnson has a beta of 0.85 — both have lower risk than the general 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 sale of the appreciated shares are taxable and the dividend distributions are eligible for the dividend tax credit.
6) We recommend holding medium risk blue-chip Canadian equities within a Tax Free Savings Account. The U.S. does not recognize TFSA as a tax savings vehicle in the U.S., and as a result, a 30 per cent tax withholding is applied on the US 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 factors 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 move investments around for new clients and save them significant tax dollars.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138.