It's been a topic of debate ever since the tax-free savings account was introduced five years ago. Which investments are better suited for a TFSA and which for a registered retirement savings plan?
Although some vehicles are better for one or the other, experts agree these decisions should be made in the broader context of a portfolio strategy that includes not only a TFSA and RRSP but a non-registered, taxable account, too.
Investments for RRSPs
The main benefits of RRSPs are that contributions of after-tax income produce a tax refund, and the money grows untaxed over time. When done right, the withdrawals are subject to a lower income tax rate than would have been payable on the initial contributions.
The major drawback, however, is that all RRSP investments receive the same tax treatment upon withdrawal, largely eliminating the advantages of dividend and capital gains income. Both of these are taxed more favourably than earned income, says Ted Rechtshaffen, president of TriDelta Financial in Toronto.
"From this perspective, it doesn't matter what you're investing in for your RRSP and what you're cashing out of your RRSP, because it gets converted into fully taxable income," Mr. Rechtshaffen says.
Still, one investment in particular is well suited for the RRSP: U.S. stocks that pay dividends. "There's essentially an agreement with RRSPs where the U.S. government will not charge a withholding tax on U.S. dollar dividends." This treaty does not apply to TFSAs or taxable accounts – though with taxable accounts, you can apply for a Canadian tax credit on withheld tax on U.S. dividend earnings.
Yet probably the best investment choice for RRSPs is fixed-income assets, says money manager Robert Broad with T.E. Financial in Toronto. By investing in fixed income, the low-yielding assets grow tax-sheltered for years. While the money is fully taxable when withdrawn, the interest earnings would be fully taxable if held in a taxable account anyway.
Ideally, Mr. Broad says investors should employ a strategy in which their RRSP holds mostly fixed income that does not grow too, too big. "Otherwise, you end up with this big chunk of money that will produce fully taxable income that could bump you into a higher tax bracket and cause OAS [Old Age Security payments] to be clawed back."
Investments for TFSAs
The beauty of the TFSA is that the money grows and can be withdrawn tax-free anytime. This makes TFSAs an excellent retirement income source because withdrawals do not affect income-tested benefits such as OAS and the GIS (Guaranteed Income Supplement).
Yet some investments are better suited for a TFSA than others. Arguably, any investment offering steady returns is not a bad option – except for U.S. dividend stocks, says Mr. Rechtshaffen.
"If you own the same stock in an RRSP and it pays a dividend of $1, you will keep that dollar in your RRSPs, but in your TFSAs, that same dollar would be worth about 70 or 85 cents depending on whether you've filled out a certain IRS form." In addition, because the dividend was earned in a TFSA – a non-taxable account – you cannot apply for the tax credit from the CRA to get back some of the money you paid in U.S. withholding tax, Mr. Broad says.
Growth stocks are another matter, whether they are from Canada or the U.S., because capital gains on stocks traded on both the U.S. and Canadian exchanges are not taxable within a TFSA.
Yet this strategy, too, has a drawback. While growth stocks can provide a nice capital gain – tax-fee in a TFSA – they are generally riskier than other assets. The investment can suffer losses just as likely as it can provide capital growth. Although capital losses in a taxable account can reduce taxes on capital gains also made in a taxable account, they cannot when held inside a TFSA, Mr. Broad says, adding that this disadvantage also applies to RRSPs.
Still, investors should seek capital appreciation in a TFSA, but in a more conservative manner. Generally, they should avoid investing in individual stocks due to TFSAs' relatively small size – the maximum room will be $36,000 in 2015.
"Instead, we would generally recommend holding stocks in a TFSA through a mutual fund or an exchange traded fund," Mr. Broad says. The reason is that these funds may sustain losses in the short term but they generally have a greater potential to grow over the long term. That may not be the case with an individual stock.
Additionally, investors could hold high-yielding fixed income in their TFSA. Keep in mind, however, that these higher-risk investments have the same downside as growth stocks when they go awry: capital losses cannot offset taxes on capital gains.
Investments for taxable accounts
What about those stalwarts of retirement saving for many Canadians: blue-chip dividend stocks traded on the TSX? Most Canadians believe these are great choices for both TFSAs and RRSPs.
In some respects, they are right. Blue chips provide steady capital growth over time as well as income from dividends, making them an excellent investment for any long-term saving account.
Yet in the context of a three-pronged strategy using all accounts, the main advantage of these securities is eliminated inside RRSPs and TFSAs, Mr. Broad says. Dividend income from Canadian firms traded on the TSX receives favourable tax treatment due to the dividend tax credit.
In some provinces, dividend income is non-taxable if personal income is low enough (less than $44,700 in Ontario, for example). Furthermore, only 50 per cent of capital gains are taxable.
That's not as good as tax-free inside a TFSA, but this makes them more attractive inside a taxable account than an RRSP.
"Again, it goes back to where you want your big pool of money at retirement," Mr. Broad says. "So in my opinion, it's attractive to have a large amount of Canadian-paying dividends at retirement in a taxable account because then you have a tax-efficient income stream from those dividends."