When to invest outside a tax advantaged account

Tax Advantaged Account

I remember back to when I was just starting out with my investments. The idea of considering a tax strategy within my investment portfolio was pretty daunting. Luckily, the Canadian government offers young investors with tax advantaged accounts to allow investing to start on a tax deferred or even tax free basis. This article will walk you through how taxes should play a role in your investment portfolio strategy early on.

tax documents on the table

Tax advantaged and tax free investing accounts

When we start investing, we usually do not start out with large sums of money. Our investments are small chunks off of each pay cheque (hopefully) that get automatically (hopefully) deposited into our investment accounts. In Canada, the Federal Government offers tax advantaged investment accounts that allow modest sums of money to be invested without having to worry too much about taxes.

Tax Advantaged Accounts in Canada

In Canada, the 2 major examples are the Tax Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP).

The TFSA allows you to take money that you have earned and already paid income tax on, and then put it into investments which grow over long periods of time. All of that investment growth is tax free. You can contribute up to $6,000 of post-tax money per year. Over long periods of time and with compounding, this is an amazing way to grow your wealth and not even have to worry about taxes at all. You can invest not only in safer investments like GICs or simply just cash, but also in stocks, mutual funds, ETFs and bonds. There are restrictions though – no real estate, no private equity, no art and no crypto (unless in a crypto ETF!).

The RRSP is a little different. In an RRSP, instead of investing money that you’ve already paid taxes on, you invest money before tax but then down the road when the money is withdrawn from the account, you pay tax on the gains. This is why you often get a tax refund for making RRSP contributions – it is the governments way of making you whole for taxes you paid on gross income that you contributed to your RRSP that year. You have the same level of variety in investment products as you do in a TFSA. RRSPs are also very popular because they are often employer sponsored in “Group RRSPs”, where an employer will deduct a portion of each paycheque and put it into an RRSP account for the employee and then also contribute a matching contribution from the employer. These are golden, because any dollar for dollar match from an employer is the same thing as an immediate 100% return on investment before the money has even been invested! You can contribute up to 18% of your previous year’s income, up to a maximum (in 2021) of $27,830.

So to max out both your TSFA and RRSP accounts, assuming a 35% tax rate on your TFSA money, you’d need to invest almost $40,000 of pre-tax money. For most Canadians, that is more room than they need, or have the ability to use, each year to invest. Therefore, for most Canadians, they may never need to worry much about taxes on their investments!

When to invest outside a tax advantaged account

As mentioned above, there are limitations on what investment products can be held within an RRSP or a TFSA. In general, sophisticated investment products and those reserved for accredited investors (people who have over $200,000 in income, $1m in liquid assets or $5m in net worth) are not eligible within TFSAs and RRSPs.

One scenario where you might decide to direct investment dollars to a non-registered (taxable) investment, is if the after-tax returns from that investment are expected to be higher than the pre-tax returns from what you’d expect within the products allowed within your registered accounts. As an example, let’s say you use your TFSA to invest in well diversified low-cost index funds that track the S&P 500 stock index. You expect that based on historical results, your investment will return 8% per year. Remember, in a TFSA, there is no future tax, so 8% is 8%.

Someone comes along with an opportunity to invest in a rental property. In rental properties, your money can be leveraged with debt and so the pre-tax return on equity expectations once income, principal reduction and appreciation are factored in are expected to be 25% per year. Real estate is capital in nature, so appreciation is taxed at 50% capital gains rates, while income is taxed at income rates. But putting that complexity aside for a moment, there is no margin tax rate in Canada where a 25% pre-tax return is reduced down to below 8% after taxes. Therefore, logic dictates that your money is better allocated to the real estate investment.

Of course, there are far different risk profiles to an index fund and a rental property, which is one of the reasons one generally results in higher returns than the other.

Another reason to invest outside your tax advantaged accounts is to invest in an asset class which is not permitted within the account. More and more these days, investors big and small are diversifying into alternative asset classes. Just last week Robinhood announced that its investors will gain access to pre-IPO shares which are not yet traded on a stock market exchange. Generally speaking, private company shares are not permitted to be held in tax advantaged accounts. Other asset classes like real estate (title ownership), art and collectibles, NFTs/Crypto and private equity investments are all also not permitted. These asset classes, I assume, are deemed to be sophisticated by the Canada Revenue Agency, and therefore assumed to be reserved for “wealthy people who don’t need tax advantages”. These arguments are becoming less and less relevant though. If you desire diversification away from general debt and equity securities, that is another reason to invest outside your tax advantaged accounts.

Always question your assumptions

Popular wisdom is popular for a reason. Steady investments into TFSA and RRSP accounts is a time tested way to build wealth and its worked for millions of Canadians over the years. However, there are inherent limitations to these accounts to be aware of which could have a very significant opportunity cost to your long term wealth creation. The decision around allocation of capital to tax advantaged accounts versus non-registered investments becomes more and more relevant as your income and wealth rises and you have the ability to invest in a wider array of asset classes.

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