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Most Canadian investment advisors never need to worry about tax efficiency for their clients beyond their registered retirement savings plans (RRSP) and tax-free savings accounts (TFSA).
Only about 10 per cent of tax filers contribute the maximum allowable amounts to the government registered accounts, according to the Canada Revenue Agency (CRA).
But for high-net-worth clients and those looking for an investment edge, investing in non-registered accounts can open up a world of tax efficiency similar, yet different, from RRSPs and TFSAs.
“Non-registered trading accounts give you a lot of flexibility in investing,” says Paul Harris, partner and portfolio manager at Harris Douglas Asset Management Inc. in Toronto.
The most common advantage is the ability to turn losses into gains through tax-loss selling, he says. That allows investors to offset losses from the sale of equities against taxable gains from the sale of other stocks.
Under the current tax rules, half of the capital gains in non-registered accounts are taxable. Tax-loss selling allows half of the capital losses to be deducted from those gains going back three years or forward indefinitely.
In comparison, tax-loss selling is not permitted in RRSPs and capital gains are taxed fully when funds are withdrawn. Utilizing capital losses to offset capital gains is not possible in a TFSA because capital gains are never taxed.
Mr. Harris says it’s important advisors utilize all three account types as part of an overall tax-saving strategy.
“Fill up the buckets that are non-taxable first [such as a] TFSA, RRSP, and then fill up your non-registered account,” he says, adding that the TFSA is the most tax-friendly.
Fixed income such as bonds and guaranteed investment certificates bring the biggest tax advantage in a TFSA because the income they generate would be taxed fully in an RRSP and non-registered account, Mr. Harris says.
An RRSP is a better choice for longer-term investments because taxes can be deferred until they are withdrawn – ideally in retirement, and there can be crippling tax consequences for early withdrawals.
“You have the benefit of it growing for 20 or 30 years tax-free in an RRSP. That’s a very powerful saving vehicle,” he says.
The advantage of holding dividend-paying securities
As a general rule, Mr. Harris says the best type of investment to keep in a non-registered account is Canadian dividend-paying stocks that qualify for a dividend tax credit. That includes Canadian dividend-paying mutual funds or exchange-traded funds (ETFs).
“Buying a Canadian dividend portfolio makes a lot of sense,” he adds.
On a broader level, it’s important to ensure the sum of all accounts represents one diversified portfolio that includes a broad mix of investments, including all major sectors and geographic regions.
“As a [portfolio] manager, you want to look at all these accounts and find where the best place is to put all the asset classes,” he says.
Denise Batac, tax partner at Crowe Soberman LLP in Toronto, also says retirement-focused investors should utilize their RRSPs and TFSAs fully before investing in a non-registered account, and cautions not to make tax considerations – such as tax-loss selling – override sound investment decisions.
“Whether you sell securities and incur losses should be part of your overall investment strategy. Don’t let taxes make the decision whether you’re liquidating investments,” she says.
“If you are looking to liquidate investments, you would want to do proper planning to make sure the losses you generate are going to offset gains you’re otherwise going to realize so you can minimize the taxes.”
That being said, Ms. Batac says some types of investments, such as non-Canadian dividend-paying stocks, are not tax-efficient in a non-registered account.
“Foreign dividends are taxed as regular income [in a non-registered account] and don’t get the dividend tax credit,” she says. “If you’re making the decision as to whether to hold foreign investments in registered or non-registered accounts, the preference would generally be to hold them in a registered account like an RRSP or TFSA.”
Short-selling, derivatives and cryptocurrencies
However, for advisors looking for more sophisticated investment vehicles for clients, registered accounts can be limiting. Short-selling – borrowing equities with the intention of profiting when their value falls – is not permitted in RRSPs and TFSAs.
“Short-selling is only allowed in margin accounts,” Ms. Batac says.
The same ban applies to short ETFs, also known as bear ETFs, and some, but not all, mutual funds that short equities.
Qualified investments for RRSPs and TFSAs, according to the CRA, include any security that’s listed on a designated stock exchange, except for certain derivatives.
Derivatives, including put and call options, warrants, debt obligations and ETFs are permitted, according to the CRA. Futures contracts and derivative instruments where losses could exceed the original cost are only permitted in a non-registered account.
Bitcoin is permitted in RRSPs and TFSAs, but many newer or less-established cryptocurrencies are not.
“Generally speaking, when you’re looking in the cryptocurrency world, a lot of those investments are deregulated,” Ms. Batac says. “Unless they’re sitting on a stock exchange, the position is going to be that they’re non-qualifying investments.”
In cases of many new or speculative investments in which the CRA has not determined eligibility, the only tax relief is a non-registered account.
“It’s going to take some time when new investments come out before the CRA starts commenting on whether these are qualifying or non-qualifying investments,” Ms. Batac says.
Investors buying the newest and latest products in their TFSAs could also become victims of their own success if the CRA determines arbitrarily that they’re professional traders.
“There are a couple of factors [the CRA] looks into [to determine] whether you’re a professional trader – the frequency of trading, and your knowledge and expertise,” Ms. Batac says.
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