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Dec 28, 2018

Leveraging Tax-Advantage In RRSP, TFSA And Non-Registered Accounts Part 1

by Moez Mahrez

Moez MahrezHave you ever stopped to think what type of account you should be using to maximize your investment returns? You can have great returns, but if you don’t pay attention to the way you use different investment accounts, your returns may end up less than you had hoped. When it comes down to it, your real return is what you get back when you cash out your investments. We are guaranteed to be taxed, we cannot escape it (for the most part.) However, what we can do is optimize the use of our tax-deferred, tax-exempt and even taxable accounts. In Canada, our tax-deferred account is the Registered Retirement Savings Plan (RRSP), our tax-exempt account is the Tax-Free Savings Account (TFSA) and our taxable accounts are known as non-registered accounts. For Exchange Traded Funds (ETF) investors, there are a few considerations that need to be made depending on the type of ETF and type of account being used to get the most out of your returns and avoid being taxed unnecessarily.


Let’s start with RRSP basics. First, the RRSP is a tax-deferred account, meaning contributions reduce your taxable income, taxing you less in the short term, but you eventually pay taxes on the amounts you withdraw. The RRSP is efficiently used if you contribute to it when your income tax bracket is higher and withdraw when your income tax bracket is lower. All capital gains and dividends are taxed only when they are taken out of the RRSP and are taxed as regular income rather than at the lower tax rates of capital gains and dividends. However, compounded tax-sheltered returns through an RRSP over a long period of time can outweigh higher tax rates.

The RRSP has a specific advantage when it comes to U.S. stocks and ETFs that pay dividends. U.S. dividends are normally subject to a withholding tax of 15%, but the Internal Revenue Service (IRS) (the U.S. equivalent to the Canada Revenue Agency (CRA)) treats Canadian RRSP accounts as if they are tax-free. Therefore, a wise course of action is to own U.S. listed ETFs in your RRSP. However, if U.S. companies are held in a Canadian-listed ETF, the withholding tax will be applied within the ETF itself, so it is best to avoid Canadian-listed funds that hold U.S. equities. Holding a Canadian-listed fund that holds Canadian stocks is fine as Canadian dividends are tax-sheltered until withdrawal as per standard tax-deferral rules.

One fund allocation consideration to keep in mind is how much exposure you want to the U.S. vs Canadian and international markets. For example, if you are an investor who prefers to maximize RRSP contributions, it may not be ideal to only hold U.S. ETFs and stocks in your RRSP if you are not optimistic about the U.S. markets. On the other hand, if you want more U.S. exposure but have a limited amount to invest it may be optimal to focus your U.S. equity ETFs in your RRSP and reserve Canadian and international equity ETFs for your TFSA and non-registered accounts. With respect to international equity, it gets a little trickier and requires some discretion. On the one hand, international equity ETFs result in less withholding tax if the ETF is U.S.-listed, and on the other, a Canadian-listed ETF that holds the underlying international stocks directly helps reduce currency exchange costs. The most inefficient combination from a tax perspective would be to hold a Canadian-listed ETF that gets international exposure through another U.S.-listed ETF.


The TFSA has a unique advantage of allowing investors to be completely exempt from investment income tax on dividends, capital gains and interest. Unlike the RRSP, the TFSA is not tax-deductible on contributions, nor does it result in taxing investors upon withdrawal. In other words, the TFSA has no tax implications whatsoever. Of course, if the TFSA did not have its own limitations, Canadians wouldn’t bother with any other accounts. The TFSA contribution limits are important to understand to avoid over-contribution penalties. The TFSA program began in 2009 and each year since then you are permitted to contribute an incremental amount allotted to that year. Any withdrawals in a given calendar year become unused contribution room to carry forward for the next year. If you haven’t contributed to a TFSA until today and are a Canadian resident or citizen of 18 years or older in 2009, your maximum contribution in 2018 would be $57,500, which is still quite a bit of room to work with.

To compare the RRSP and TFSA, let’s assume you start out with $10,000 in each account. At a rate of 10% average annual return for 10 years you will end up with $25,937. When you withdraw the full amount from the RRSP, you will be taxed at whatever your marginal tax rate is, so for example, a marginal rate of 29%, leaving you with $18,415. Withdrawing that same amount from the TFSA leaves with the full amount of $25,937. In return terms, that’s a 10% average annual return for the TFSA and 7.86% for the RRSP (calculation includes tax refund benefit assuming 29% marginal tax rate). This implies that high growth investments may be more optimal in a TFSA rather than an RRSP.

For many investors, the TFSA is an appropriate place in a portfolio to venture into high growth spaces like health care, artificial intelligence or even a niche space in specific country. A caveat to this is that with high growth comes high volatility in the interim years, meaning capital losses can occur. TFSA limits are based on your contribution amount not your balance, so losses do not add to your contribution room. Furthermore, investors should expect a longer time horizon to make up for higher volatility. There’s nothing wrong with holding some high growth stocks and ETFs in an RRSP, however, assigning “portfolio tasks” of high growth for TFSA and lower yielding bonds and U.S. dividends for RRSPs has worked very well for many investors.

In contrast to using the TFSA as a great spot for high growth funds, it is also important to factor in an allocation for emergency funds. The flexible nature and no tax consequences of withdrawal make the TFSA a primary choice over the RRSP for accessing emergency savings.

With respect to ETFs, Canadian equity ETFs seem to provide the most tax efficiency as no returns or dividends are taxed in the TFSA. It is less than optimal to hold U.S. equity ETFs (Canadian-listed or U.S. listed) that pay dividends because the foreign withholding tax of 15% would apply (the only way a TFSA can be “taxed”). This makes it even more optimal to hold U.S. equity ETFs in a RRSP as discussed earlier.

For international exposure it is best to stick to Canadian-listed ETFs that get exposure by holding underlying international companies directly rather than through another non-Canadian-listed ETF. U.S.-listed ETFs with international exposure are the least tax-efficient way to invest in the TFSA because they are subject to the 15% foreign withholding tax on dividends and a possible extra withholding tax from the subject country on dividends and capital gains.

Non-Registered Accounts

Conventional wisdom tells us to stick to tax-sheltered accounts whenever possible and to take full advantage before resorting to taxable (non-registered) accounts. However, we often take taxable accounts for granted. The primary, obvious, advantage we overlook is that there are no contribution limits or withdrawal penalties like those experienced with registered accounts. This gives investors with more investable money a lot more flexibility in general, and when withdrawing for retirement or other purposes. Another less obvious advantage that non-registered accounts have over TFSAs and RRSPs is the ability to perform tax-loss harvesting strategies. This is a strategy by which you use a losing investment to your advantage by purposefully selling it to incur a capital loss, thereby reducing your total capital gains tax bill. Furthermore, tax-loss harvesting offers flexibility as investors can apply capital losses from the last 3 years or hold on to them for the indefinite future to offset capital gains. Having an accountant is useful for advice on tax-loss harvesting strategies.

The advantage of holding ETFs in a taxable account over mutual funds is that ETFs are traded like stocks so you only incur capital gains once you sell your holdings. With mutual funds, capital gains are less in your control because they are recorded based on when the fund manager buys and sells holdings within the portfolio. When looking at mutual funds it is important to look at the turnover percentage; a high number indicates lots of buying and selling.

ETFs which have a fund structure that re-invests dividends instead of paying them out have proven to be quite advantageous for taxable accounts. Investors only realize capital gains when they sell ETF holdings, instead of upon receiving distribution from dividends. Furthermore, capital gains are usually the lowest taxed form of income, giving investors even more tax savings. Canadian-listed ETFs work decently in a taxable account as Canadian dividends are taxable, but eligible for the dividend tax credit and capital gains can be deferred. For U.S. equity ETFs, dividends are taxable as well but eligible for a foreign tax credit. For international exposure it is best to use Canadian-listed ETFs that hold the underlying companies directly. You will be taxed on dividends and capital gains as usual, but you can also take advantage of a foreign tax credit if available. It is best to avoid international exposure though U.S.-listed ETFs because an additional 15% withholding tax will be applied (although can be offset with foreign tax credit).

We have gone through some of the mechanics of registered accounts and taxable accounts and how to use them to our advantage. We have also discussed what to be aware of when investing in ETF in those respective accounts. Of course, there is no one-size fits all rule and investors must use discretion according to their personal circumstances.

In summary, it is generally most tax-efficient to hold U.S.-listed ETFs that hold U.S. equity in an RRSP, Canadian-listed growth stocks in a TFSA and Canadian-listed ETFs in taxable accounts. For RRSPs it is best to avoid Canadian-listed funds that hold U.S. equities, TFSAs should avoid U.S.-listed ETFs with international exposure and taxable accounts should avoid international exposure though U.S.-listed ETFs. Stay tuned for Part 2 of this edition where we will provide an analysis of our favorite ETFs for each account.

ETF investors interested in sharpening their skills can sign up for an ETF Mutual Fund Update membership at Access to the website includes recommended lists, investment tools and a monthly newsletter with insights and updates to the ETF and mutual fund universe. Canadian MoneySaver members get an exclusive 25% discount off the annual subscription fee by following this link:

Moez Mahrez, CFA, Investment Analyst

at 5i Research Inc., Waterloo