Posted by Tim Stobbs on January 15, 2010
When you have a TFSA, an RRSP and an open investment account, which assets will ideally go in which accounts? These are general ideas to keep in mind while planning your TFSA contributions.
Once there are funds inside the TFSA, a huge benefit is that income and capital gains are not taxed. The practical application is that transactions no longer trigger tax consequences, much like inside an RRSP. A TFSA is very useful for high turnover trading. If you are investing (or speculating) using a strategy that frequently sells positions, it would result in realized gains and losses in an open investment account. Within an RRSP, the taxes are all paid at withdrawal. But in a TFSA, those gains are never taxed.
Generally, it is recommended to put fixed income (bonds and GICs) inside an RRSP and capital growth (equity) in an open investment account. There are two benefits to having the fixed income inside the RRSP: avoiding paying taxes on the income and keeping the slow growth in the RRSP. Since the RRSP withdrawals will eventually all be taxed, it makes sense to keep the total as low as possible. High-yielding securities could then pose a difficulty. Take, as an example, 5% preferred shares at $20. They will grow from $20 to $25 at maturity (often years in the future) and pay $1.25 per year taxable income each year. The RRSP will shelter the income, but it will also increase the value. A TFSA is the perfect account for an investment like this.
The general strategy in regards to types of income is: interest or business income, dividends, capital gains, return of capital. This assumes that you believe you will earn the same return in each case. Some examples of each type of income follow. Interest income is usually paid by bonds and GICs. Business income is earned from income trusts, although this will be taxed in 2011 and become like dividends. Dividends are usually paid on preferred shares and common shares. Capital gains come from growth in market value, usually from common shares or junk bonds. Finally, return of capital is often paid by REITs (real estate investment trusts). Because they have depreciation, the income they pay may not be taxable. It may eventually be classified as capital gains. The choice isn’t so simple, because you may expect greater growth from capital gains (buying growth stocks cheap), it may be best to hold that investment in a TFSA, instead of a GIC at 3%.
One strategy using TFSAs is available to all adult couples: income splitting. The government doesn’t really care who makes the TFSA contributions. If a couple has only one income, or two incomes in different tax brackets, it will probably make sense to have one spouse contribute to both TFSAs. That way, it is possible to use more TFSA room. If one spouse makes $20,000 per year and the other makes $80,000 per year, it doesn’t really matter who pays which bills. $10,000 can be used (in 2010) to contribute $5,000 to each TFSA, regardless of who earned the money. It is possible that, in retirement, there will be enough money in each TFSA that the couple can choose who will make their other withdrawals in order to minimize the total tax bill.
Canadians now have more ways to save tax while saving and investing for their future. Each has distinct benefits and uses. The RRSP offers deductions, and I recommend making an RRSP contribution first if your income is over about $40,000. Many Canadians have debt, and I recommend paying down debt before making a TFSA contribution. This is especially true if the TFSA would hold fixed income and the debt has a higher interest rate. A TFSA is usually the lowest priority, unless it is for short term savings or for a high-yielding investment. In the comments, please share how you use your TFSA differently than your RRSP and debt repayment.
Robert is a Certified Financial Planner (CFP®) in Calgary who develops financial plans and also gives objective advice regarding all types of savings and investment products. He believes that not having money worries can allow people to spend their time in other meaningful areas of their life. Robert is married, has three children and is involved in his church, in his community association and in the school. Robert is on track to retire at age 42, although he and his wife plan to change careers and work for the benefit of children.