With Canada’s complex income tax rules and all of the scenarios that investors could face, I think it makes sense to talk about how a growth investor might tackle the structure behind his or her investments. After all it’s easy to put together a model portfolio of stocks. But how that portfolio is constructed in real life will be different depending on your age, income sources and overall income level. It’s different for everyone. I’m not a tax expert so this article reflects my personal beliefs.
Most Canadians who make investments have the option of doing so inside of an RRSP or spousal RRSP, in a plain old investment account, or in a new structure known as a tax free savings account.
Let’s look at the RRSP first. In my casual conversations with people outside of the financial industry over the years, this seems to be the one vehicle most people are aware of. But sadly, many folks have been so indoctrinated into RRSP thinking that they don’t even consider investing in stocks outside of their RRSP.
There are only two benefits of investing in an RRSP. First, you get a tax deduction on your investment in the year that you make it. Second, you can accumulate gains inside of your account tax free. This all comes at a cost though. When you withdraw the money later in life it counts as regular income. You get no tax breaks. And besides that, if you are a long term shareholder, you don’t need to worry about tax-free growth because it’s built in to your investing methodology.
Let’s use the example of the fictitious character, Roy, the barber in David Chilton’s famous personal finance book The Wealthy Barber. He’s focused on long-term investing and saves 10 per cent of his pay. RRSP contributions wouldn’t benefit him very much because he’s only get a tiny tax deductions. Yet he’d be stuck paying a higher tax rate upon becoming wealthy in retirement. Instead, I think Roy is better off forgoing the initial tax deduction and accumulating wealth inside of the tax free savings account (TFSA).
With a TFSA you can invest up to $5,500 of after-tax income into stocks or other investments and not ever pay tax on the growth of that money, or future withdrawals. For low income earners this is quite possibly the only investment vehicle you’ll ever need.
At the opposite end of the spectrum let’s look at the lawyer who earns $300,000 per year and has a spouse who earns only $20,000 doing part time but immensely enjoyable work. This lawyer would be best served by using the full amount of his RRSP room to contribute to his spouses retirement account. He’s get a big tax write-off up front and set the couple up for income splitting later in life. The lawyer’s would have plenty of money left to invest in a TFSA and a non-registered plain vanilla investment account. Since spouse earning $20,000 could also invest fully in a TFSA because the lawyer’s income can easily handle all of the couple’s budgetary requirements.
If you happen to have tax-sheltered accounts (RRSP or TFSA) and non-sheltered accounts (plain old investment account), then it makes sense to put the right stocks in the right accounts.
Say you want to have a mix of long term growth stocks, shorter term speculative stocks, and also dividend paying stocks. Which stock should go where?
Not that I want to encourage speculation, but no matter what anyone says there will always be people who want to invest for the short term and look for the fast buck. I’d rather put those types of investments in a tax-sheltered account. This way there would be no tax on gains should I end up tripling my money on an options contract or the next speculative tech name that gets gobbled up by a competitor. I’d be able to reinvest all the money tax free.
As much as I consider myself a growth investor, I diversify. Some of my personal holdings pay substantial dividends. Especially for Canadian stocks, I prefer to keep the big dividend paying stocks outside of the RRSP because this source of income is taxed at a much lower rate compared to bond interest or foreign dividends. If I’m going to hold U.S. stocks that pay dividends, I’ll often prefer to hold them inside an RRSP to shelter that income from tax.
Finally, we have long term growth investments. I think these are important investments for young investors to make, no matter what vehicle they are placed in. But where should you place them? If I’m convinced I’ll be holding a stock for decades, I prefer my non-sheltered accounts. I don’t need to worry about avoiding taxes until I sell, so I don’t care much for the tax-free growth. I’m getting it anyway. And I’d rather pay the lower tax rate on capital gains compared to RRSP withdrawals, which are taxed as regular income.
But if I’m making an investment in a young growth stock that I think might get acquired in the next 5-10 years, I’ll want to avoid triggering early capital gains tax way before my retirement age. So this is something I’d more likely put inside of a tax sheltered account such as a TFSA or RRSP.
At the end of the day, tax planning considerations matter. But the decision to invest for long term growth is paramount. Invest early, invest often, and just use common sense when thinking about tax sheltered accounts and how to use them.