Allocation angst: Juggling the TFSA with your RRSP

National Post


Tax-efficient asset allocation across your various investment accounts just got a bit more complicated this RRSP season with the introduction of the tax-free savings account.

The traditional rule was to hold any fixed income investments inside your registered plans, which allows otherwise fully taxable interest to be sheltered from annual taxation.

It often followed that equities, in which only 50% of the gains are taxable, are best held in non-registered accounts, since any profits made on the sale of equities in an RRSP are taxed at your personal marginal tax rate when withdrawn.

If those equities were dividend-paying Canadian stocks, all the more reason to hold them outside an RRSP so as to benefit from the dividend tax credit, which can lower your marginal tax rate on Canadian dividend income by more than 50%.

Enter the TFSA, in which income and gains accumulate tax-free and withdrawals are also tax-free. How should we allocate our investment portfolio among the new TFSA, RRSP and non-registered accounts?

For starters, it is still good practice to allocate fixed-income investments to an RRSP, but maybe makes more sense to put the first $5,000 of such investments in a TFSA.

But where should dividend-paying equities be held? It may depend on the company's country of residence.

Canadian preferred shares are popular today due to their high yields and favourable dividend tax treatment. Since such preferential treatment is only available for stocks held in a non-registered account, Canadian dividend-paying securities are better off held outside an RRSP.

Foreign dividends are not eligible for the dividend tax credit and are taxed at your full marginal tax rate when earned outside of an RRSP or TFSA, seemingly making them ideal for your RRSP or TFSA. But the problem with foreign dividends is that in most cases, a foreign non-resident withholding tax is applied by the foreign jurisdiction before the dividend is received in Canada.

If you hold the foreign stock in a non-registered account, you can claim a foreign tax credit against your Canadian tax payable for the amount of tax withheld. But if the foreign dividend is paid into an RRSP or TFSA, the foreign tax withheld is non-recoverable and no credit is available.

The Canada-United States tax treaty exempts U.S. dividends from withholding tax when paid to an RRSP or RRIF. But that same break does not apply to a TFSA, making U.S. dividend-paying stocks better off in RRSPs.