Where To Invest What

Today on the Canadian Dividend Investing newsletter, we’re going to cover taxes. Well, sort of.

I know, I know. Taxes are not a very fun activity. Most would rather do just about anything than get their things together for the Tax Man. So we procrastinate, suddenly finding inspiration to do those other jobs we put off months ago. Because they seem so much better than the alternative.

Then, April 29th rolls around, we collectively have an aw crap moment, and an hour later, the taxes are done. And you’re left wondering why you procrastinated so long, because that wasn’t so bad.

Rather than get into the nitty gritty details of taxes, we’re going to Pareto Principle the whole thing. Most Canadians would benefit from simply getting the big picture part of taxes right, and then letting their accountants (or tax software) worry about the details. So that’s all we’re worried about today, the big picture stuff.

We’re going to focus on which types of investments to put into each account, making sure to give you the knowledge you need to avoid any major tax mistakes.

Let’s get started.

What to put in your non-registered account

Canadians essentially have six different accounts they can invest in, depending on their situation:

• Non-registered (Or taxable, or margin account. Your brokerage might call it different things, but tax-wise it’s all the same)

• RRSP

• TFSA

• FHSA

• LIRA

• RESP

We’ll focus mostly on the first three for this article, since they’re the primary accounts that 90% of Canadian investors use. Pretty much every serious investor has a taxable account, an RRSP, and a TFSA, but comparatively few end up with cash in a LIRA or FHSA (that’s First Home Savings Account for those unfamiliar, and it’s pretty much like a TFSA). And RESPs are their own different ball of wax.

So let’s start off by talking about non-registered accounts, and the types of investments that work best there. And to do so, we have to talk about taxes.

As I’ve mentioned approximately 4,000 times on the ol’ Tweeter app, dividends are taxed pretty well in Canada. In fact, taxes fall to pretty much zero if all you have is dividend income. That makes retiring early on a portfolio of dividend-paying securities incredibly friendly from a tax perspective.

My buddy Jim figured this out early, and uses the philosophy to pay pretty much zero tax in retirement.

The key to maximizing value out of your taxable account (from a tax perspective, anyway) is to make sure you’re putting Canadian dividend stocks only into that account. Other types of income producing investments don’t get nearly the preferential tax treatment.

But Nelson. If it pays a dividend, then isn’t it a dividend stock? What’s the difference here?

Great question, Italics Man. Not all “dividend” stocks are created the same. Certain ones, like REITs, don’t actually pay dividends. They pay distributions, which look and act like dividends — except at tax time.

We’ll get more into the complexity of REITs and other types of stocks that don’t actually pay dividends in a bit, but for now we’re just focused on keeping those out of your taxable account. It’s far simpler come tax time if you just take the easy way out and hold REITs in your RRSP or TFSA.

The easy way to identify a Canadian stock that doesn’t pay a dividend is to look for anything with a .un in its ticker symbol. This includes all REITs, but also stocks like Alaris Equity Partners (TSX:AD.un) and Chemtrade Logistics Income Fund (TSX:CHE.un). The .un is an easy giveaway, and so are words like “income fund” or “trust” in the company’s name.

Ultimately, however, you’ll want to verify with the company directly. Luckily, we live in the 2020s (basically the future!) and that information is easily available on the company’s website. Google “_____ dividend tax info” or something similar, and it’ll take you to where the company has published that info.

What to put in your RRSP?

Now that we’ve established what to put into your taxable account, let’s talk a little bit about RRSPs. What kinds of investments should you put in there?

Since RRSPs offer tax deferred growth, the answer is you can put pretty much anything safely into your RRSP. Any dividends (or distribution income) generated by the underlying investment is going to accumulate in the account, tax free. You’re only taxed on it when you take it out, which is decades down the road for many of you.

You can even safely throw U.S. dividend stocks in there, and they won’t be subject to the 15% withholding tax that hit dividends in other types of accounts. You keep 100% of those dividends, rather than paying any taxes.

Still, there’s at least one type of investment I’d avoid putting in my RRSP.

The big thing to avoid putting in your RRSP is something that grows quickly and doesn’t pay much of a dividend, say something like Dollarama (TSX:DOL). If Dollarama is a buy and hold investment for you, then you can successfully defer taxes for decades simply by not selling a single share. Then, when you do eventually sell, the proceeds are taxed as capital gains.

The same investment inside your RRSP would be pretty much the same, until the end. The same tax deferral happens until you’re forced to sell in your RRSP, which will happen at some point. The government forces RRSP holders to eventually convert the account to a RRIF and start withdrawing. When that happens, the gains are then withdrawn and taxed as normal income.

In this specific situation, it makes far more sense to hold something like Dollarama for decades and then slowly sell it off in your taxable account, rather than doing the same thing in your RRSP.

And on the flip side, if this high-growth investment doesn’t work out, you’ll end up with a nice taxable loss — which is useless inside of an RRSP.

How about your TFSA?

I believe that the TFSA is the best thing to happen to Canadian savers in a generation. It’s the first account I fund every year, and it’ll be the last I withdraw from in old age.

In fact, if I had my financial life to do over again, I would’ve changed my RRSP strategy in 2009, when TFSAs were introduced. I would’ve funded my TFSA first, and only put money aside into my RRSP when I had higher earning years. That would’ve maximized the RRSP benefit at the time, and presented me with a smaller tax liability in the future.

Despite the TFSA’s flexibility, there’s still at least one type of investment you don’t want to put in there — U.S. dividend stocks. 

Unlike RRSPs, which are recognized in the tax treaty between Canada and the United States, U.S. dividends inside of your TFSA are in fact subject to the 15% withholding tax on dividends. And while there are ways to get that tax back as a Canadian taxpayer who loses it in a taxable account, there’s no such remedy in a TFSA.

Other than that, pretty much anything fits. High-growth compounders work well in a TFSA, since you’re not taxed on the proceeds, or the withdrawals. So do REITs or other types of dividend stocks that actually pay distributions instead. You can reinvest that capital back into the original investment, or put it to work in something new — and do it all without worrying about the taxes.

Even regular old Canadian dividend stocks work pretty well inside your TFSA. You can reinvest the dividends on a tax-free basis, and very easily take money out in retirement, all without worrying about the taxes.

A quick section on REIT taxation

REIT taxation is boring, complicated, and just plain annoying. Which is why the easy solution is to just stick ‘em in your RRSP or TFSA and not worry about it.

However, there are likely a few of you who got excited one day and bought a REIT or six in your non-registered account. So, let’s take a quick (really quick, I promise) look at REIT taxation.

A REIT’s distribution will never be taxed as dividend income. It just isn’t possible based on the structure of the investment.

But that doesn’t necessarily mean they’re a bad investment tax-wise. REITs can do certain things to help their investors minimize taxes, and many of them do.

First, let’s take a look at what a REIT’s distribution will look like from a taxation perspective. Basically, it’ll be made up these three things:

1. Other income (interest income)

2. Capital gains

3. Return of capital

Most of the income you’re going to get from a REIT will be other income. This makes sense; after all, a REIT’s entire business is it holds real estate and rents it out. Other income is basically this rent (less operating expenses), and that’s fully taxable for any landlord.

But REITs have options beyond that. For instance, if a REIT sells a building or three during the course of a year, that gets factored into the tax calculations at the end of the year. That sale could get categorized as capital gains (if the REIT made money) or return on capital (if the REIT didn’t).

So, quite often, your distribution will be a combination of interest income, capital gains, and return on capital.

Here’s an example, from Crombie REIT. As you can see, in some years the portion of capital gains is far greater than others.

To put this simply, each year Crombie shareholders would pay capital gains taxes, other income (i.e. regular income) taxes, and then get a certain amount of return of capital. This shrinks your cost basis, which eventually results in larger capital gains when you sell the REIT in the future.

I could go (much) further into this, but I won’t. There’s really no need to go much further than the basics, unless you’re an accountant — or a glutton for punishment.

The bottom line

This is probably easiest to digest if I put it into chart form, so here you go:

This isn’t meant to be tax advice, nor is it supposed to be a substitute for an accountant or financial planner. Rather, these are simply rules of thumb that you can follow to minimize your tax liability, or headaches, in the case of REITs. Remember, we’re trying to Pareto Principle this — we’re want to get it mostly right, and I believe these rules of thumb will allow most investors to do so.

Folks with more complicated lives should consult a professional that specializes in the problem they’re having.

One more thing

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