Canadian Mutual Fund, ETF, and RRSP Advice
News and information on RRSP's, TFSA's, mutual funds, exchange traded funds, and Canadian personal finance. Efficient Market Canada advocates using indexed mutual funds and indexed exchange traded funds (ETF's) to build a low-cost, efficient self-directed RRSP. We analyze RRSP and TFSA asset allocations, tax strategies, and review the financial literature as it relates to RRSP and TFSA investment, and personal finance for Canadians.
|Contributed by: martingale |
When deciding which account to use for which asset class, you should put Canadian equity ETFs in your TFSA, and US ETFs add well as bonds in your RRSP. Let's look at the reasons why, and some of the edge cases that arise where this advice is wrong.
The key to thinking about this question is to realize the differences between a TFSA and an RRSP, and make choices that maximize the advantages of each kind of account.
Fundamentally, an RRSP is a tax deferral. You get a deduction in the current year, and you pay tax in the future when you withdraw it. A TFSA is just the reverse--you get no deduction in the current year, but you pay no taxes in the future when you withdraw it. Both are excellent vehicles for saving for your retirement, although the TFSA has the advantage of being more flexible in that you can withdraw at any time.
So these are the key points we want to think about:
1. Tax deferral versus tax-free growth
2. The flexibility to withdraw at any time
3. An RRSP is a tax free account from the perspective of the IRS but aTFSA is not
These differences will guide the decision of what to put in each kind of account.
Now let's take a moment to reflect on the different kinds of assets that you will have it your retirement savings account. You will have a combination of stocks and bonds. What's the difference between these? If we think about what they really are, we arrive at this:
a) Stocks are high growth, high risk investments. They benefit from dividend tax credits, and capital gains tax treatment
b) Bonds are low growth, low risk investments. They have no particular tax benefit--they are taxed as regular income
If we put all this together for most people, most of the time it makes sense to load your bonds and your US ETFs in to your RRSP, and your Canadian ETFs into your TFSA. Of course, you might run out of TFSA room and start loading stocks into your RRSP as well, just because you have to.
Because the odds are your bonds are going to grow less than your stocks. Your stocks, over the very long term, should be expected to return something between 5% and 10% per year on average depending on how well the markets do. Your bonds on the other hand, while very safe, will show only a couple of percentage points in growth. Much less.
Let's look at a scenario where you put 50% of your investments in bonds, and 50% in stocks, and suppose that the bonds grow by 2% per year while the stocks grow by 7% per year. In that case after 25 years you will have $54,000 in stocks and only $16,000 in bonds, as the stocks grew by much more than the bonds did. With stocks in your TFSA and the bonds in your RRSP, you are going to pay tax on $16000 in withdrawls from your RRSP and no tax on the $54,000 withdrawl from your RRSP. This is MUCH better than the other way around--paying tax on $54000 from your RRSP and getting the $16000 in bonds out of your TFSA tax free.
With respect to Canadian versus US ETFs, the fact that the Canada US Tax Treaty predates the creation of TFSA accounts is significant. In an RRSP withholding taxes on US equities will be waived. Outside an RRSP the fund will withhold taxes. In a taxable account you can claim these withholding taxes back on your return, but in a TFSA these withheld taxes are simply lost. Therefore it is better to hold a US ETF in your RRSP.
There is one caveat to all this though, that will require you to stop and think about what you might need the money for: that flexibility that the TFSA offers. It's great that the TFSA allows you to withdraw money tax free at any time. It makes it a good place to put emergency money. And emergency money should NOT be in stocks. Stocks are only a good investment when you have a long time horizon, ten years or more. Emergency money you might need at any time.
So, if you are planning to use your TFSA for emergencies, you should put that money in a short-term bond fund and not in equities. Otherwise on the day you need it, if there's been a fall in the stock market, the money might not be there.
If you have used all your contribution room and will be investing in a taxable account, consider using it for bonds and Canadian equities. Bonds have the lowest return and thus generate the least tax. Canadian equities are taxed preferentially, with a dividend tax credit. However you are better off putting both into a tax protected account if you can.
Put Canadian equity ETFs in your TFSA, and bonds along with US ETFs in your RRSP, unless you need the money for emergency purposes -- in which case hold short-term bonds in your TFSA.