Most Canadian investors know they need to shelter investments from taxes as much as possible but these can be taxed differently depending on which account holds them. Professionals call this Asset Location. Here’s how to optimally place them in the most tax-efficient vehicles.

By Curtis Travis

Special to Financial Independence Hub

Most Canadian investors learn the first rule quickly enough: shelter it. Fill the registered accounts before a dollar goes into a plain taxable one. It is the single most valuable habit in Canadian investing, and if you read this site you have almost certainly done it.

Almost nobody does the second step.

Here it is: the same investment is taxed differently depending on which account holds it. Not the same investment in a different year, or bought at a different price: the identical holding, on the identical day, taxed differently because of the drawer it sits in. Professionals call this Asset Location. It costs nothing but a few minutes of thought, and getting it backwards can quietly cost you thousands over a couple of decades.

Three facts drive the whole thing.

The first is that the dividend tax credit — the break that makes eligible Canadian dividends so gentle in a taxable account — is lost inside a registered account. A TFSA or an RRSP isn’t paying tax in the first place, so the credit has nothing to offset. It simply evaporates.

The second is that American dividends arrive with tax already taken off the top. The United States withholds 15% under the Canada/U.S. treaty. In a taxable account you can generally claim that back as a foreign tax credit. In an RRSP the treaty exempts it entirely. And in a TFSA, an FHSA or an RESP it is gone for good: the treaty doesn’t recognise those accounts, and there is no tax return on which to recover it.

The third is that interest is taxed as ordinary income, the harshest treatment there is. It has the most to gain from any shelter at all.

Line those up and a rough map falls out. Not a clever one: the kind a CPA will refine but not overturn.

American dividend payers belong in the RRSP, where the withholding disappears. Interest-bearing holdings belong in a registered account too, because they are punished worst outside one. Canadian dividend payers are the natural residents of a taxable account, where the credit actually does its work; so when registered room is tight and something has to sit outside, the Canadian banks and utilities are, for most people, the last things that need sheltering. And your highest-growth, longest-held positions belong in the TFSA, where a large gain is not merely deferred but never taxed at all.

That last one is worth sitting with. A TFSA doesn’t defer the tax on a thirty-year compounder. It cancels it.

Now the part that catches careful people.

The RRSP exemption on American dividends only applies when you hold the American shares, or an American-listed fund, directly. A Canadian-listed fund that owns American stocks pays the withholding inside the fund, before the money ever reaches you. In a taxable account that is survivable: the fund passes the tax through on your slip and the credit is still yours. In an RRSP it is simply lost, and you will never see it on a statement.

This surprises people who did everything else right. They bought a Canadian-listed U.S. equity fund, put it in the RRSP because that is where American exposure is supposed to go, and quietly gave up the treaty benefit they were trying to capture.

Where good intentions get expensive

Two more pieces of fine print, because this is where good intentions get expensive.

The RRSP is a deferral, not an exemption. Everything that comes out comes out as ordinary income: capital gains and dividends included. A gain that would have been taxed at the favourable capital-gains rate in a taxable account is taxed in full when it leaves an RRSP. The deduction you took going in is what pays for that. And by the end of the year you turn 71 the account must be wound up, for most people into a RRIF, which from the following year pays you out on a schedule whether you want the money or not.

The TFSA has three habits worth knowing. Room you withdraw comes back: but not until the following January, so a withdrawal and a re-deposit in the same calendar year can quietly push you over your limit. The penalty is a tax of 1% per month on the excess, which is not a rounding error. And a TFSA is for investing: the tax agency has taken the position, and the courts have backed it, that an account run like a day-trading business can have its gains taxed as business income, tax-free wrapper or not. Buy well and sit still and you will never meet that rule. Continue Reading…