One of the first dilemmas that people face is that they know that they need to start investing, but they also have debt and other upcoming expenses. Plus, they don’t know which type of accounts to get started with. This page will go over some basics about what accounts are, the different types, and some of their basic characteristics. That is used to give a “usual” investing account sequence to consider when making your own choice about where to start.
Your debt and security are your first accounts to invest in.
Investing is meant to be a long-term endeavor. You must ensure that you are in a safe financial state to invest without the risk of having to sell, to get the cash back, in the next 3-5 years.
That means paying down your debt to a level where you can sleep at night. You can’t invest if your emotions will easily take control of you. Fear is a powerful emotion and is magnified by debt.
You must also have access to “emergency cash”. That could be room on your line of credit, or cash in a savings account, with enough available to cover unexpected emergencies. The usual recommended amount is 3-9 months of living expenses (depending on your job security) plus some allowance for semi-predictable expenses like car/house repairs and tax installments.
There is a mathematical argument for investing rather than paying debt. However, the math does not matter if you do not have your debt and security established. You cannot risk investing when you won’t be able to stick to the long-term plan.
You “open” an account. Don’t “buy it”.
A common misconception is that investment accounts are something “you buy”. Like, you go to the bank and “buy” an RRSP or a TFSA. The bank is where most people go for financial advice, and they want to sell you something. They want to sell you their mutual funds – an investment product.
Mutual funds, exchange-traded funds (ETFs), stocks, and bonds are all financial products that you buy. The account is just what holds the product or instrument. The container. You open the container so that you can then shop and put stuff in it.
Basic Account Characteristics
Registered Accounts vs Taxable or Non-Registered Accounts
Registered accounts are government-regulated tax shelters.
The most commonly used are a Tax-Free Savings Account (TFSA), a Registered Retirement Savings Plan (RRSP), and a Registered Education Savings Plan (RESP). There are also different flavors of these like an RRIF, LIRA, or RDSP. The biggest limiter to most registered accounts is that they have maximum contributions.
What makes them “tax-sheltered” varies by account type, but it comes down to two main characteristics: tax deferral and tax drag. More on that in a moment.
Non-registered accounts are tax-exposed and sometimes called “taxable accounts”.
Personal taxable accounts can come as a “cash” account or a “margin” account. The main difference is that a margin account allows you to borrow some money from the brokerage to invest (with restrictions and costs) and a cash account requires you to have the cash in the account to buy the investments with. Income from interest, dividends, and the taxable half of capital gains in these accounts is subject to personal taxes.
A corporation can also own a taxable “cash” or “margin” account. A corporation is considered a separate legal entity and can have a corporate investment account. Investment income in a corporate account is subject to the corporate taxation system. It is complex, but a corporation can be very efficient or very inefficient depending on the income type and whether the corporation is flowing enough income out to its owners.
Tax Deferral
Tax deferral is investing using pre-tax money. You pay the tax later when you access it.
Tax deferral gives you more upfront capital to invest and grow, but that capital also carries a tax liability.
The prime example is an RRSP where your contribution is deductible dollar for dollar against your income. So, no income tax is paid and there is more capital to invest. That is 100% tax deferral, but that does not necessarily mean tax reduction.
A corporation is also a tax-deferral vehicle. You either pay ~12% tax or ~27% tax upfront, depending on the company size, and the rest is deferred until you take the money out later. Again, that may or may not result in an overall tax reduction. It depends on the tax rate that you are deferring from and the eventual withdrawal tax rate. A purely capital gains based portfolio may come out ahead, but most diversified investments also have interest or dividends that are less tax efficient in a corporation.
Tax deferral can result in more, or less, money in your hands after tax. The future matters.
If you contribute/deduct to a tax-deferred account while in a high tax bracket and take the money out later in a lower tax bracket, then the tax is reduced. More money in your hands after tax. However, if you deduct while in a lower tax bracket and pay the tax at a higher tax bracket later, then it is a tax increase. Less money in your hands after tax.
It is more common for people to earn more during contribution years than in retirement. So, tax deferral is great for most people. However, that does not always happen. Someone may build lucrative businesses and passive income streams, have major jumps in their income over their career, or the government broadly raises tax rates. That could mean more tax than if the liability had been removed earlier and less after-tax money to spend.
What can still make an RRSP good even if the tax-deferral situation isn’t perfect is that it also reduces tax drag. If the alternative to putting or leaving money in an RRSP is to invest it in a tax-exposed account, then an RRSP still usually comes out ahead even if there is a slightly higher tax bracket at drawdown.
I didn’t put the First Home Savings Account (FHSA) below. It not only has tax deferral (a tax deduction now), but also tax elimination (tax-free withdrawal) when used to buy a qualifying home. A massive gift.
Tax Drag
Tax drag is the drag on annual growth of investments due to the tax owing on income.
Interest, dividends, and half of realized capital gains count as taxable income. Having to pay the tax on that income stunts compounding growth. For example, interest or dividends in a personal or corporate cash account generate a tax bill each year that you must pay. If you have capital gains, then you only trigger tax when you sell, and realize the gain.
In a TFSA, RESP, or an RRSP, there is no tax on any of that income. Well, one wrinkle. There is a foreign withholding tax (FWT) on foreign dividends that may be lost. In a taxable account, the FWT can be recouped from most developed countries and US-listed holding dividends in an RRSP are exempt. The impact of FWT is complicated, but fortunately small.
Comparison of Account Characteristics
The restrictions, tax deferral, and tax drag characteristics of some common investment account types are summarized in the table below. A model portfolio of 80% stocks and 20% bonds is used to illustrate tax drag, but that would vary slightly based on the actual funds used. The analysis also uses the same mix in each account with no attempt to optimally match income type to account type (asset location).
Deciding Which Account Types To Use & When
Each investment account type has different characteristics. So, they may all play some role in a larger investment portfolio. However, most investors starting don’t have enough money to invest in everything at once. They must choose which accounts to invest in first. One possible sequencing strategy is illustrated below and the rationale is described in the subsequent text.
Prioritize Tax-Sheltered Registered Accounts
The most valuable account to use (if you qualify and can max it out consistently each year) is the FHSA. Not only do you get an income tax deduction (tax-deferral), but also a tax-free withdrawal for a qualifying house/condo (tax-elimination). If unused, it can be rolled into an RRSP later.
Generally, using registered accounts first makes sense to maximize the time for tax-sheltered growth. When starting out, your income and tax burden is also usually lower than it will be later in your career. So, if you have the money, stuffing it into after-tax registered accounts first (TFSA and RESP).
Using tax-deferred accounts later when your tax rate is high maximizes the odds that you will realize a tax reduction instead of just deferral. Or if you’ve maxed out your TFSA, FHSA, and RESP.
A high-income spouse may opt to contribute to a spousal RRSP instead of their own to give better income-splitting options in the event of retiring before age 65.
Professionals Or Businesses That Can Incorporate
Most high-income professionals will have to save more than the space in their registered accounts to fund their retirements. If a profession that can incorporate, that becomes an excellent option for tax-deferred investing once their registered accounts are full. A corporation can eventually become tax inefficient if it generates large amounts of income and very little is passed out to the owners. That problem usually takes a long time to develop (if ever) and there are multiple ways to deal with it.
High-Income or Big-Savers Who Overflow Their Registered Accounts
For high-income investors or any-income investor that cannot incorporate, max out their registered accounts, and have excess personal cash to invest must use a personal taxable account. A cash account may also be an excellent way to income-split if a lower-income spouse’s income is not needed for living expenses and is invested in their name instead. For couples with a similar income, a joint account ensures a simple seamless transition if one of you dies before the other.
Investing For The Kids
If you have after-tax money to invest for your kid’s future, then a self-directed RESP is an excellent option. Siblings can share a family RESP for more flexibility. The earlier an RESP is started, the better to take full advantage of tax-free compounding and grants. Aim for $2500/yr to get the full CESG grant. If in low-income years, you may even get extra grants. So, don’t delay if you can help it. Those with excess after-tax money sitting around or as a gift from relatives may want to frontload with a lump sum, followed by annual contributions.
Another account option to invest excess money for kids is to use an informal trust. This an account directed by an adult for the benefit of a minor. The contributions are irrevocable and must go to the child’s benefit. When they turn 18, it becomes fully theirs. Under their control. This can be a way to hold excess money when an RESP is full or being slowly filled to get the grants. It is also a way to help teach your kids about investing.
Complex Products, Strategies, & Accounts
The basic account types described above are enough for anyone to tax efficiently invest. However, more complex financial products will be marketed towards you as alternative ways to temper your tax bill. You can also opt to use more complicated investing strategies, like asset location tax optimization. Discussing them all in detail is beyond the scope of this interactive guide to DIY investing, but they are mentioned elsewhere on my site. They can be useful, and I do use some of them personally. However, you definitely need to be an educated customer.
When confronted by these options, ask yourself the following four questions?
Are you trading reduced taxes for increased fees?
The fees may be associated with the advisor needed to execute the complex plan. If executing a complex plan yourself, there is a risk of more opportunity to behave poorly.
Fees are often embedded within complex products like an IPP, whole life insurance, or a private equity pool. The opacity of the investment instrument, lingo used, and data vacuum make them hard to accurately tease out.
Are you increasing or decreasing your options?
Most complex products lock up your money. They are like a marriage. You should date extensively before committing. Be prepared for bad feelings and a big hit to your wealth if you want to separate.
For example, whole life insurance must be borrowed against (a loan) to access the money before you are dead. Most of the benefits of whole life insurance are towards the end of your career or life.
If you are sold an independent pension plan for the right reasons, it usually means you have a large portfolio. It also means you will be forced to take income each year. That may be good since it encourages spending before you become the richest corpse in the graveyard, but it limits tax planning somewhat.
With a private equity pool investment, you are usually required to lock the money in for a period of time. Even when there are options to redeem, they involve delays and you some of the value of your stake will be lost to the fact that illiquid investments have a larger bid-ask spread for transactions.
Are you really diversifying more?
Some products are sold with the notion that they are helping you to diversify more. To be providing useful diversification, a product must have a poor correlation to the other asset classes that you own. Determining that may be simple.
For example, whole life insurance is not going to fluctuate with the markets. Conversely, it can be very hard to determine for assets like private equity and real estate due to the data. For example, private equity marketing materials will usually show some date about higher returns and a low correlation compared to publicly traded markets. However, when you adjust for the lack of daily pricing and leverage (risk) used, the return and correlation is very similar to small cap value stocks.
Private equity and real estate can provide excellent returns that are magnified by leverage. However, it is not a “free lunch”. Much depends on the actual manager and specific investments (specialization as opposed to diversification).
Who is in charge? You or your investments?
The reason why we invest is to grow our money so that we can use that money to better our lives and the lives of those around us. If you are running into increasing taxes to a level where special tax strategies can be useful, then it means you have a large portfolio and/or income.
Should you increase complexity or should your perhaps work less for money and spend more living. If you love working for money, then another option is to give more. Either through charity, which has personal, tax, and societal benefits. Or by paying the high tax bill because you think the government does a great job spending your money.