Hello everyone and welcome to the Retiring Canada Podcast. In today’s episode, we're going to discuss how to best utilize the non-registered account as a retirement investor.
Specifically, we are going to cover:
- Understanding the difference between registered and non-registered accounts
- The three ways your non-registered account is taxed
- Planning opportunities for retirees
- The potential impact on government benefits
- Lastly, a few action items for you to consider
The financial jargon in Canada doesn’t do consumers any favors. Terms like RRSPs, non-registered accounts, TFSA, LIRA, PRIF, LIF, and DC plan can be confusing. It’s understandable how hard it is for the average retirement investor to sort through it all.
To make things simpler, you can categorize these accounts into two broad types: non-registered accounts and registered accounts.
Registered accounts are registered with the government and allow you to save or invest money under certain terms and conditions. This category includes RRSP, TFSA, RESP accounts, etc. An investor can put money into these accounts, which offer tax benefits and, in some cases, grants, withdrawal restrictions, and more.
Non-registered accounts, which some of you may call “open” or “taxable” accounts, do not have these specific conditions. For simplicity, I will refer to them as non-registered accounts today. These accounts offer more flexibility with no contribution or withdrawal limits. Additionally, you have the option to hold a non-registered account jointly with your spouse, unlike most registered accounts except for the Registered Education Savings Plan.
One important distinction is how a non-registered account is taxed. Unlike a TFSA, which has completely tax-free growth, or an RRSP, which compounds tax-deferred but is taxed as income when withdrawn, the non-registered account is subject to three distinct kinds of tax: interest income, dividend income, and capital gains. These types of income are not created equal.
The first is interest income. Most of you have likely received a tax slip for this kind of income. This can be generated in your savings account at the bank, through monthly distributions from a high-interest savings account, or income received from a GIC. Interest income is taxed at your marginal tax rate and is the most tax-inefficient of the three.
The tax inefficiency of interest income is significant for a retirement investor, especially in terms of how their retirement portfolios are structured. We’ll discuss more on that later.
The next kind of taxable income in a non-registered account is dividend income. Dividends are generated when an investor holds a share of a company. In return for investing in that company, the investor is rewarded with an eligible dividend from the publicly traded company.
For tax purposes, the dividend is grossed up, and then a dividend tax credit is applied. This form of income is more tax-efficient than interest income but may require the added risk of owning a publicly traded company. There is another crucial aspect to dividends that greatly impacts your government benefits like OAS, which I’ll discuss shortly.
The last is capital gains. This kind of income is triggered when the underlying investment is deemed disposed of or sold. In simple terms, the price you sell the investment for minus the amount you invested determines your capital gain. You then apply a 50% inclusion rate to determine the taxable capital gain.
Let’s run through an example of an investor who is in the 38% marginal tax rate and how they would be taxed in their non-registered account on $10,000 of each kind of income.
First is interest income. If our hypothetical investor received $10,000 of interest income, they would be required to pay CRA $3,800 in tax, or 38%. In this case, our retirement investor is left with $6,200.
Next is dividend income. Assuming the $10,000 is in the form of a dividend, a dividend gross-up and dividend tax credit are applied, leaving an effective tax rate of 20.5%, or $2,050 in tax, and $7,950 in their pocket.
Lastly, capital gains. When we apply the capital gain inclusion rate, only 50% of the $10,000 is taxable at this investor’s marginal rate of 38%. The effective tax rate is 19%, meaning there would be $1,900 in tax, leaving the investor with $8,100 after tax.
In summary, with a 38% marginal tax rate, an investor would be left with the following after-tax amounts:
- Interest income: $6,200 (38% effective tax rate)
- Dividend income: $7,950 (20.5% effective tax rate)
- Capital gains: $8,100 (19% effective tax rate)
In simple terms, in a non-registered account, dividends and capital gains are tax-preferred compared to interest income.
So, who should care about this? If you dislike paying taxes, you likely care about minimizing them. However, before you start investing in a non-registered account, there are a few other boxes you should check:
1. Have you contributed to your RRSP or spousal RRSP to optimize your tax situation now and at retirement?
2. Have you and your spouse maxed out your TFSA accounts?
3. Is there a small amount of lingering mortgage debt that should be paid off shortly before you retire before investing more elsewhere?
Once these are addressed, the non-registered account will start to make more sense as a long-term investment account.
Many of you may already find yourselves in this situation with no liabilities, maximized registered accounts, and investments being held in an individual or joint non-registered account with your spouse.
If this is the case, let’s explore a few planning opportunities and one significant pitfall to be aware of.
The first is the use of a spousal loan. This is useful when one spouse has been the sole or majority income earner and has accumulated a large sum of non-registered investments in their name. The higher-income-earning spouse loans money to the lower-income spouse at a prescribed rate set by the government.
From then on, all investment income inside the non-registered account is taxable to the lower-income-earning spouse rather than the higher-income spouse. This strategy is complex and requires annual monitoring by your financial professional, so seek advice to see if it makes sense for you and your family.
Another planning opportunity is to utilize return of capital investments. These investments distribute a portion of your initial investment back to you as income. This return of capital is not taxable. However, these investments reduce your initial investment’s cost base and only delay an inevitable taxable event in the form of a capital gain. With this strategy, you are essentially kicking the tax bill down the road to a later date, which can be beneficial for some retirement investors.
Next is the use of corporate class investments. These mutual funds or ETFs are registered as corporations. The investment income generated inside these funds is fully taxable as capital gains, which is tax-preferred. Corporate class funds can distribute dividends from Canadian stocks and capital gains dividends, both of which are taxed more favorably than regular income. They cannot distribute interest or foreign income, which is retained within the corporation and subject to taxation unless offset by expenses.
Another strategy would be to utilize segregated funds. These are more like insurance contracts, holding traditional investments. Segregated funds can have guaranteed maturity and death benefit amounts. When held inside a non-registered account, they also bypass probate and go directly to a beneficiary. However, these funds can carry high fees, often around 3%, and are best suited for optimizing estates or protecting assets from creditors, not as core holdings for retirement income purposes.
Lastly, consider asset location. Now that you understand the three types of income—interest, dividends, and capital gains—you can take a broader look at your overall retirement portfolio and search for inefficiencies.
For example, let’s assume you have two accounts: a non-registered account and a RRIF account, each with $500,000. The non-registered account holds GICs, and the RRIF account holds a traditional dividend equity portfolio. Both accounts distribute 5% annually. This results in $50,000 of taxable income, taxed fully at a 38% marginal rate, leaving you with $31,000.
Now, switch the asset location: put the GICs in the RRIF and the equity portfolio in the non-registered account. The RRIF is still fully taxable and distributes 5%, while the equity portfolio distributes 5% as dividends. Factoring in the RRIF income, the dividend gross-up, and tax credit, our retirement investor now has approximately $35,000 in their pocket. Simply switching the asset location saved our investor $4,000 without changing their risk tolerance.
Sounds straightforward, right? However, there is one significant pitfall that can increase your taxes by 15% if not planned for properly: the OAS recovery tax.
Remember the dividend gross-up and dividend tax credit for dividends in a non-registered account? Although dividends are tax-efficient to your bottom-line taxable income, the dividend tax credit is not applied when calculating social benefit repayments. If you earned $10,000 in dividends, they would be grossed up to $13,800, not $10,000, when determining OAS repayment eligibility. This grossed-up amount impacts your net income before adjustments (line 23400 on the tax return).
So, while dividends are tax-preferred, you need to be aware of how they impact your social benefits. If you want to learn more about avoiding the OAS clawback, listen to episode 15 of the podcast.
Now you have a crash course in understanding non-registered accounts and how they can play a part in your overall retirement plan.
Let's get into the action items for today’s episode.
1. If you have an individual or joint non-registered account along with registered accounts like an RRSP, review the underlying investments. Is there an opportunity to change the asset location to mitigate current and future tax liability?
2. If you are aggressively accumulating for retirement and there is a significant income difference between you and your spouse, talk to a professional about the spousal loan strategy to shift future taxable investment income to a spouse without triggering attribution concerns with CRA.
3. Review your overall retirement income plan as it relates to your long-term goals. If you have charitable intentions, plan to gift to your kids early, or simply want to minimize tax now and over time, developing a tax-efficient plan in your non-registered accounts that factors in all aspects of your finances will help ensure you get the most out of your money while keeping the government out of your pocket as much as possible.
That will do it for today’s episode.
For the links and resources discussed, please check the link in the show notes or visit retiringcanada.ca.
If you enjoyed the show, please subscribe and leave us a 5-star review on your favorite podcast app.
Be sure to sign up for my weekly Retiring Canada newsletter.
And remember, when it comes to your retirement, don’t take chances.
Make a plan so you can retire with confidence.
All comments are of a general nature and should not be relied upon as individual advice. The views and opinions expressed in this commentary may not necessarily reflect those of Harbourfront Wealth Management. While every attempt is made to ensure accuracy, facts and figures are not guaranteed, the content is not intended to be a substitute for professional investing or tax advice. Please seek advice from your accountant regarding anything raised in the content of the podcast regarding your Individual tax situation. Always seek the advice of your financial advisor or other qualified financial service provider with any questions you may have regarding your investment planning.