Many of you know that each year, Mrs. T and I aim to max out our RRSPs and TFSAs. Once we’ve maxed out our RRSPs and TFSAs, we then start transferring money in our taxable accounts and invest in Canadian dividend paying stocks that pay out eligible dividends. Recently a reader (let’s call her Karen) reached out to me and asked me what to do now that she has maxed out her RRSP and TFSA.
Reader’s question (edited slightly for clarification):
After years of neglecting my RRSP and TFSA, in 2020, I set a goal of maxing out my RRSP and TFSA. I’m happy to say that I hit this goal at the end of 2020. I already maxed out the new TFSA contribution room at the beginning of 2021 and I am in the process of maxing out my RRSP as well. I’m just waiting to file my 2020 tax return so I know exactly how much RRSP contribution room have for this year. Anyway, I was wondering where I should put my money once I max out both my RRSP and TFSA contributions. Should I do what you and your wife do and invest Canadian dividend stocks in my taxable account? Or should I consider investing in an index ETF like XEQT? But I’m not sure if I have to pay the 15% withholding tax on XEQT’s distributions.
I am 43 years old, single, do not have any dependents, and have no mortgage or other debt. I currently do not have a taxable account and I want to make sure I am as tax efficient as possible. I don’t have any pensions through work so I want to set up my investments so I can fund my retirement. Who knows, maybe early retirement is on the horizon for me. Can you help me?
First of all, congrats Karen! That’s fantastic that you have maxed out your TFSA and RRSP at the end of last year and are tracking to max out both TFSA and RRSP this year. It’s also amazing that you have no mortgage or other debt. Amazing!
TFSA and RRSP – The basics.
One thing that drives me crazy is when people say that they’re investing in their TFSA and RRSP when they’re merely transferring cash into these accounts. The TFSA and RRSP are simply different account types. Moving money into your TFSA or RRSP doesn’t count as investing! The TFSA and RRSP are accounts that Canadians can utilize to grow their investments tax-free. In other words, it makes very little sense to keep your TFSA and RRSP in cash and earn the ultra-low interest rate. It also makes very little sense to buy GICs. For most Canadians, it makes the most sense to invest in stocks and/or index ETFs in your TFSA and RRSP.
A TFSA, as the name suggests, is tax-free, meaning once you deposit money in a TFSA, everything you earn is tax-free. This includes any capital gains, dividends, and interests.
A RRSP, on the other hand, is not exactly tax-free. RRSP deposits give you a tax deduction at your marginal tax rate. The money in an RRSP can grow tax-free. But when you make a withdrawal, the amount is counted as working income and is taxed at your marginal tax rate. The key strategy behind the RRSP is that your marginal rate should be higher when you’re working and your marginal rate should be lower when you’re in retirement. Thus allowing you to make withdrawals and pay less tax.
Generally speaking, it’s best to max out your TFSA before maxing out your RRSP. This is especially true for young folks who just entered the job market or folks with a low income who are expecting their income to grow in the future. For higher income earners, you definitely want to take advantage of the RRSP to bring you down to the lower tax bracket, if possible.
Obviously, if you can, maxing out your TFSA and RRSP is the best approach.
A word for other readers
Karen is single, has no dependents, and has no debt. This may not be the case for everyone else. If you have already maxed out your RRSP and TFSA, you may want to look at other ways to make things as tax efficient as possible before investing in a taxable account.
For example, if you have a mortgage or any other debt, it may be a good idea to pay down those debts. Yes, at the current low mortgage rate, it might be more worthwhile to invest and get a potential higher return rather than paying down the mortgage. But paying down the mortgage means a guaranteed return (i.e. you always know your mortgage rate). On the other hand, it is not guaranteed that you will always make money on your investments. Stocks have a long term return rate of around 8% but there are years that the stock market is down 20% or more. Furthermore, some people simply sleep better knowing their property is paid off.
If you have kids, you may want to consider putting money in an RESP. By contributing money into an RESP, you will receive The Canada Education Savings Grant from the government for a total of up to $7,200 per child. The best thing about an RESP? The taxes are paid by the student when the funds are withdrawn for post-secondary education. Since students typically have very low income, taxes paid should be very minimum.
I maxed out RRSP and TFSA now what?
So, what should Karen do now that she maxed out her RRSP and TFSA? Some people may treat their RRSP and TFSA as two individual portfolios, then treat the taxable account as another portfolio. I think that this is the wrong approach. Rather than treating them as individual portfolios, I think you should always look at all of your investments across the different accounts as one portfolio. You then invest and re-balance accordingly.
In terms of tax efficiency, here’s is a quick summary of what we invest in in our different accounts:
- Canadian Income trusts
- Canadian REITs
- Canadian stocks
- Canadian index ETFs
- US stocks that do not pay any dividends (i.e. Tesla, Amazon, Facebook, etc)
- Income trusts (Canadian and/or US)
- REITs (Canadian and/or US)
- US stocks
- US index ETFs.
- Canadian stocks
- Canadian index ETFs
- Canadian stocks
- Canadian index ETFs
It is best to hold US dividend stocks inside an RRSP so that you don’t get hit by the 15% withholding tax. If you hold US dividend stocks in a taxable account, not only you’ll get hit by the 15% withholding tax, the dividends are treated as working income and taxed at your marginal rate. Sure, you’ll get a foreign tax credit, but it’s not really worth it. Keep US dividend stocks inside your RRSP!
You may have noticed that US non-dividend-paying stocks may be an option for the TFSA. Since stocks like Tesla, Facebook, Amazon, don’t have dividends, you don’t have to worry about the 15% withholding tax on dividends. And since these stocks are high growth stocks, any gains you make in your TFSA is completely tax-free (but these high growth stocks are very volatile and a positive return is never guaranteed).
Now I have ignored fixed income, bonds, and GICs because the rates are terrible nowadays. For readers who want to lower risk, they should invest in fixed income, bonds, and GICs inside either their TFSA or RRSP, because these incomes are taxed at 100% of your marginal rate.
So what should I invest in my taxable account?
So what should Karen put in her taxable account now that she has maxed out her RRSP and TFSA? Well, we definitely want to make sure she can be as tax efficient as possible. So the two possible approaches are: Canadian stocks and Canadian index ETFs.
One possible option is to invest in Canadian stocks. It doesn’t matter whether the Canadian stocks pay dividends or not. We invest in Canadian stocks that pay dividends because we want our money to generate predictable dividend income. If you’re interested in Canadian dividend stocks, you may want to check out these articles:
- Our dividend income & dividend portfolio
- Best Canadian dividend stocks
- Best Canadian dividend stocks – DGI community picks
- Dividend investing FAQ
- How to start investing in dividend paying stocks
If you don’t want to deal with dividends, you may want to invest in non-dividend paying Canadian stocks like Shopify.
One very important thing to keep in mind when investing in a taxable account is that you need to keep track of your adjusted cost base (ACB). Usually your brokers can keep track of this for you but I highly recommend keeping a spreadsheet yourself for record keeping sake. If you decide to enroll in the dividend reinvestment plan in your taxable account, it is vital to keep track of your ACB.
Canadian index ETFs
Another investment possibility is to invest in Canadian index ETFs. I like index ETFs because they provide instant diversification across the different asset classes. Index ETFs like XIC or VCN may be a good choice if you aren’t comfortable with holding individual Canadian stocks.
Some readers may wonder if it makes sense to hold the popular all-in-one ETFs like VBAL and XGRO in their taxable accounts. I personally think these all-in-one ETFs are great if you don’t want to worry about re-balancing. The all-equity ETFs like VEQT and XEQT may also be an option if you do not want to hold any bonds in your portfolio.
Since all of these all-in-one and all-equity ETFs hold US stocks, the 15% withholding tax on distributions is applicable. However, this is not something investors have to worry about since the fund companies take care of the withholding tax prior to paying out any distributions.
If you decide to invest in one of these ETFs, I wouldn’t worry too much about the withholding tax on distributions, because it’s a very small portion of the entire distribution. Using this foreign withhold tax calculator, I determined that for XEQT, the withholding tax drag is only 0.01%. While distributions from Canadian companies are treated quite favourably, any distributions from a foreign source will be taxed at 100% of your marginal rate (you do get a foreign tax credit).
For simplicity sake, this is why we prefer investing Canadian dividend paying stocks in our taxable accounts.
Summary – What to do after maxing out RRSP and TFSA
So what do you do when you have maxed out your RRSP and TFSA? For Karen, the best approach is to invest in either Canadian dividend paying stocks or Canadian index ETFs. My preference is Canadian dividend paying stocks due to tax efficiency, predictable income, and simplicity.
Now if you have any debt, it makes sense to pay off your debt prior to investing in taxable accounts.
If you have any kids, it makes sense to contribute money to their RESPs before investing in a taxable account.
Maxing out your RRSP and TFSA is a great accomplishment. If you are in this situation, congratulations, you’re always doing quite well.
Dear readers, do you have any thoughts on my suggestions to this reader? Have you maxed out your RRSP and TFSA?