Thanks to everyone who participated in The Personal Finance Clinic during the month of May. We received a total of 27 questions that myself, the moneygardener and Canadian Capitalist will be answering over the next while.
Today’s question comes from Adam,
“I’d like to see a step-by-step on where to put my investments. Should I first max out RRSPs, then put it in the TFSA and if anything is left over (probably not) use a non-registered account? Do you have a ‘put your investments here’ guide as to where to place certain investments? I’m primarily a dividend income investor sprinkled with some index funds. I assume I should have all these in my RRSP until maxed and the put the remaining div. producing stocks in a non-registered. Is there ever a time where I should put div stocks outside of an RRSP even if I have contribution room?”
First Adam I’ll point you towards a post I wrote in April titled, Determining a Master Portfolio Allocation, which outlines my experience with developing a plan for investing, as a Canadian investor, in a Registered Savings Plan (RSP), Non-Registered Portfolio and Tax Free Savings Account (TFSA).
The first question you need to answer about maxing out your RRSP’s is what marginal tax rate your income is currently taxed at. If you make over $65,000 per year in 2009 and live in Ontario your marginal tax rate on income will be 32.98%. If you contribute the maximum amount you’re allowed, 18% of your 2008 annual income or $21,000.00, you can expect to receive a return from an RSP investment of approximately 32.98%. The benefit of contributing to a RSP is that your contributions are eligible for a tax rebate at your marginal tax rate, all gains are compounded on a tax deferred basis and US based dividends are exempt from withholding tax.
The main drawback, in your situation, is that any Canadian dividends you receive aren’t eligible for the dividend tax credit within a RSP. If you held all your Canadian dividends outside your RSP in a non-registered account you would only pay 7.45% tax on those dividends when making $65,000 versus 32.98% for ordinary income. This is a situation where even if you have contribution room you may want to consider holding Canadian dividend paying stocks outside your RSP or TFSA depending on your income. A great tool to use for calculating the various tax rates on your income is a calculator provided at Walter Harder & Associates. Building a non-registered portfolio of dividend paying stocks is one method I currently use in order to create a tax-efficient income stream for retirement that will hopefully outpace inflation.
Another consideration is if you currently contribute to a pension or will have pension income when you retire at age 65. If you have a pension at retirement you want to be cautious of contributing too much to your RSP early on as I’ve outlined in the post I linked to earlier. At age 71 you are required to convert your RSP into a Registered Retirement Income Fund (RRIF) that the government forces minimum withdrawals upon. If you’re an individual with a pension income of $35,000 and an RSP of $500,000 at age 71 when you convert to a RRIF you would be required to pull out $36,900 from your RRIF. That would bring your total taxable income to $71,900 and a marginal tax rate of 32.98%. The goal, for any investor building a RSP, is to contribute to a RSP when your marginal tax rate is high and pull from the RSP during retirement when your marginal tax rate is low.
I’m a strong proponent of developing a balance between RSP’s, a TFSA and non-registered portfolio depending on your situation. I will have a defined benefit plan (DBP) at retirement for the pension I currently contribute to and as I’ve shared in Determining a Master Portfolio Allocation I don’t intend to have too much money in any one account for reasons of taxation at age 71. Achieving both a balance and flexibility in my taxable income during retirement is one goal that I take seriously in my financial planning.
What I suggest any investor do is carefully consider your personal financial situation at this moment and your financial situation at retirement. Contributing to an RSP without any pension is a great way to build up savings for retirement, but the new TFSA will start to play a key role in future years as an effective savings vehicle and the opportunity for the Canadian dividend tax credit in a non-registered portfolio is something you will want to consider. What works best for you will depend on your unique situation and seeking professional advice to get you started may be a good option.
Adam: Take your time to consider all your alternatives and don’t be afraid to think independently and outside the box in order to find the right solution. If you have further questions please feel free to comment at the end of this post of contact me and I will follow up with another post answering your questions.