Inside or out? How you pay investment fees on a registered account can make a difference
If you pay fees for the management of your registered portfolio, be it an RRSP, RRIF or TFSA, these fees are not tax deductible. That being said, a question often asked by investors is how should investment management fees for a registered plan be paid? Should they come from inside the registered plan or be paid using outside funds?
To be clear, there are a variety of fees that may be associated with registered plans, such as annual administrative fees, commissions paid to buy or sell a security within the plan, as well investment management fees. But it’s the investment management fees, which are typically charged by your broker or investment counsellor as a percentage of assets under management, that has caught the attention of the Canada Revenue Agency in recent years.
In 2016, the CRA commenced a review of the payment of fees for registered plan accounts, and, specifically, looked at the question as to whether the payment of fees by the RRSP or RRIF annuitant or TFSA holder outside of a registered plan, while certainly not tax deductible, gave rise to an “advantage” under the Income Tax Act.
The advantage rules
The advantage rules are a set of lesser known anti-avoidance rules that apply to registered plans. Where a prohibited advantage has been received, a 100 per cent penalty tax on the fair market value of the advantage applies. The Canada Revenue Agency has described the rules as targeting “abusive tax arrangements that seek to artificially shift value into or out of a registered plan.”
There are a number of ways that an “advantage” can arise. One such method is where an increase in the value of a registered plan can be linked to a transaction that would not have occurred in a “normal commercial or investment context,” and a main purpose was to benefit from the tax-free status of the registered plan. The CRA reasoned that the payment of investment management fees from outside the registered plan resulted in an advantage since it would lead to an increase in value of the property in the registered plan. The financial services industry made various submissions to the CRA, explaining that this is not always the case, as we will see below.
The CRA subsequently referred the matter to the Department of Finance, which, in the fall of 2019, announced that they did not have policy concerns with the payment of investment management fees from outside of a registered plan, and that they were prepared to amend the law to ensure that the advantage rules would not apply. This announcement, while welcomed by the industry as it now gives investors flexibility, sparks the bigger question: where should investment management fees for registered plans be paid? From inside the plan or using outside funds?
Inside vs. outside
Intuitively, you might think that you would always be better off paying fees from outside the plan (i.e. using non-registered funds), as that leaves more money inside the plan to grow unencumbered by tax. That may be true for TFSAs, so that tax-free growth within the plan can be maximized; however, that’s not necessarily the case for other registered plans. That’s because when you pay a fee with non-registered funds (i.e. from outside the registered plan), you’re paying with after-tax dollars. When you use RRSP funds to pay the fees, these are pre-tax dollars. In essence, the CRA is sharing in part of the fee. Let’s take a look at an example.
Suppose you incurred a $100 fee on your RRSP investments that you could pay from inside your RRSP or outside your RRSP (using non-registered funds.) You’re in a 30% tax bracket.
By paying the $100 fee from outside your RRSP, you’d simply be out the $100. By paying the fee from within the RRSP, you’d only really be out $70. Why? Because you use pre-tax funds to pay fees from your RRSP but you use after-tax funds to pay fees from non-registered funds. With an RRSP, the government defers collecting tax on the funds you invest in your RRSP until the time you later withdraw those funds. If you paid the $100 fee from inside the RRSP, you never withdraw that $100, so the government never gets its 30 per cent tax on the $100 and, therefore, essentially shares in paying your fee.
Since you’d have less cash in hand if you paid fees from outside your RRSP (from non-registered funds), rather than from inside your RRSP, you may well wonder (as many of us did!) why the CRA initially thought that paying RRSP fees from non-registered funds would be beneficial and potentially result in an unfair advantage, subject to the harsh, 100 per cent penalty tax.
While paying fees from inside an RRSP may yield some savings, as described above, you’d also have less funds in your RRSP, so you’d have less tax-deferred growth over time. You might eventually reach a “breakeven point,” where the benefit of paying the fees from inside the RRSP is outweighed by the additional tax-deferred RRSP growth that could have accumulated inside the plan. After this breakeven point, you’d actually have been better off if you had initially paid the fees from funds outside your RRSP, preserving the extra funds inside your registered plan. Factors that influence the breakeven point include your rate of return and your tax rate.
The bottom line
Ultimately, to have any benefit from paying fees outside an RRSP/RRIF, you have to stay invested beyond the breakeven point, which can be several decades down the road. Unfortunately, most investors can’t predict with any certainty what their rates of return or tax rates will be in the future, so it’s nearly impossible to determine what your breakeven point would be. And even if you could, you can’t be certain that you’ll stay invested long enough to reach the breakeven point, much less go beyond it and realize that benefit.
As for whether fees should be paid from inside or out, with TFSAs, it seems pretty clear they should be paid from outside to maximize the tax-free growth inside the plan. For RRSPs and RRIFs, this is not an easy question to answer, as it will depend on your investment time horizon, rates of return and tax rates.