Comparing the Tax Treatment of Different Account Types
As I write this at the end of May 2022, we are now about a month past the standard tax-filing deadline in Canada. Depending on the results of your return and your stage in life, you may have been contributing to or withdrawing from any of several distinct types of accounts that are available to most Canadians. Some account types, like the RRSP, are considered almost a default choice to invest in first because of the perceived tax advantages. However, other accounts might also be considered, and each of them will have pros and cons concerning their tax treatment.
For this blog post, I offer a brief comparison of the different tax treatments of a few of the various accounts that are available to Canadians.
Contributions to an RRSP generate a receipt that can be used to claim a deduction from your total income in a given tax year. For example, if your income put you in a 30% marginal tax rate, a $5,000 contribution would effectively reduce your tax by $1,500 ($5,000 x 30%), because the $5,000 that went into your RRSP would no longer be taxable.
If you have the contribution room and the money available but do not have very high income in a given year, you can choose to contribute but not claim the deduction in that particular year.
An RRSP is designed as an account for accumulating financial assets for retirement. However, you can withdraw money from an RRSP if you wish to, but your financial institution will be required to withhold tax on the withdrawal at the following rates (excluding Quebec):
Clever people who want to withdraw more than $5,000 while minimizing the tax withheld may think that they can take multiple $5,000 withdrawals, only having to give up 10% in tax each time. However, your financial institution will review your withdrawals and, if they see a pattern, they will withhold at a higher rate. Ultimately, you will have to pay the tax owed as you will be issued a T4RSP for your withdrawals in the year. Most likely, you will have to pay more tax than has been withheld since it will be treated identically to your income from employment.
Whether the assets in your RRSP are held in a savings account, invested in Guaranteed Investment Certificates (GICs), bonds, stocks, mutual funds, or Exchange-Traded Funds (ETFs), any income or growth is tax-free, regardless of whether you are receiving interest, dividends, or capital gains. That also means that losses cannot be claimed to reduce your taxes owing.
The only difference between a personal RRSP and a spousal RRSP is that the latter allows one spouse to contribute to the account of the other spouse so that the taxes on withdrawals will apply to the spouse who is the owner of the account. For example, Jane is a high-earning specialist physician married to John, a creative but relatively low-earning potter. A spousal RRSP is opened for John to which Jane contributes half her maximum contribution room each year. The other half she puts in her personal RRSP. Jane receives the contribution receipts for both her personal and spousal contributions. This is beneficial for her since she is in the highest (combined provincial and federal) tax bracket of 53.53% for residents of Ontario with taxable incomes greater than $221,708. John does not contribute to an RRSP because his taxable income of $46,000 means his combined provincial and federal tax rate is only 20.05%.
Maximum contributions to an RRSP in 2022 cannot exceed $29,210 or 18% of earned income, whichever is less. The high-income earner is maxed out after an income of $162,278, so in our case, Jane will be able to contribute a maximum of $29,210, whether it is all to her RRSP, or John’s spousal RRSP or a combination. However, given her marginal tax rate of 53.53%, she will reduce her taxes owed by $15,636.
If John were left to his own devices concerning RRSP contributions, he would maximize his contribution at $8,280, which at his marginal tax rate of 20.05%, would generate a refund of $1,660. Even if Jane contributed no more than John’s maximum to his spousal RRSP, she would still receive a refund worth $4,432.
Tax on withdrawals is an issue to consider, though. Let’s suppose that, on average, Jane has been contributing $25,000 per year for the last 10 years to John’s spousal RRSP including in 2022. Toward the end of 2022, John wants to withdraw $30,000 from his RRSP to update his art facilities and expand his business. This would bump up his taxable income from $46,000 to $76,000. John and Jane both think this is okay since she received about a $16,000 reduction on her taxes and John will only have to pay about $8,655 in tax.
However, money that has been contributed to a spousal RRSP that is subsequently withdrawn in the same year and up to the two previous years is attributed back to the contributing spouse. Since a $30,000 withdrawal would account for the $25,000 that Jane contributed this year and $5,000 of the amount she contributed last year, all $30,000 withdrawn would be taxed at Jane’s rate, leading to no tax advantage at all.
If John had taken out more than $75,000, he would have gone beyond the three-year attribution range, but of course, he would have been taxed at a higher rate, albeit still not as high as Jane’s marginal tax rate.
A Registered Retirement Income Fund is the counterpart to the RRSP. After accumulating money for decades in your RRSP, when you retire the common action is to convert your RRSP assets into a RRIF and begin receiving income from it. As noted above concerning RRSPs, withdrawals are charged standard tax rates and as long as the money is held within the RRIF, no tax is charged.
RRIFs have annual minimum payments (AMPs) that are based on the annuitant’s (account holder’s) age and the value of the account at the beginning of the year.
To illustrate, let’s suppose that you turned 65 in 2021 and your RRIF account was worth $100,000 as we entered 2022. You can see from the table above that your RRIF would be subject to a 4.00% minimum payment. On $100,000, that means you would need to withdraw a minimum of $4,000.
As long as you do not exceed the Annual Minimum Payment (AMP), your financial institution does not need to withhold tax. You can wait until you file your taxes the following spring. Anything over the AMP, however, would require that tax be withheld at the same rates as the RRSP tax rates on withdrawals. As an example, if you wished to take out $8,000 in 2022, that would be $4,000 above the AMP. That excess amount would have tax withheld at the rate of 10% since it is less than $5,000 above the AMP.
You also have the choice to request that a certain percentage be withheld by your financial institution in anticipation of the taxes that you will be required to pay anyway.
Once an RRSP has been fully converted to a RRIF, no more contributions can be made. Nevertheless, attribution rules might still apply. If we return to Jane and John, let’s suppose that in 2021, when John converted his spousal RRSP to a spousal RRIF, it was worth $500,000 and that Jane had contributed to the account right up to and including 2021. If we assume that John turned 65 in 2021, then the same 4% factor applies in the case of the AMP: $500,000 x 4% = $20,000. As long as John takes no more than the AMP, he will pay tax on the payment at his rate. But, if John takes out more than the minimum, let’s say $40,000, then $20,000 will be payable at his tax rate and the extra $20,000 will be attributed to Jane and charged at her rate. This suggests that, if you own a spousal RRIF, you should consider only taking out the minimum during the first three years to avoid your higher-earning spouse having to pay tax on it.
The Tax-Free Savings Account is simple. Contributions made to a TFSA do not generate a tax deduction or a tax credit. However, it is like the RRSP or RRIF in that, while the money is invested inside the account, no tax is payable on interest or dividends received or realized capital gains. Even better, when money is withdrawn from a TFSA, no tax is payable.
I should note that, as the TFSA is not an account type recognized by U.S. Internal Revenue Service, taxes are withheld on dividends paid by U.S. corporations. Furthermore, these withheld taxes cannot be countered by claiming a foreign tax credit when you file your return, as the TFSA is not taxable under Canadian tax law.
Attribution is generally not an issue when it comes to contributing to your spouse’s TFSA. If Jane has money to give to John, she can give it to him to contribute to his TFSA and it will only ever be tax-free when he withdraws it.
Now, I did say generally because there is an exception that you need to be aware of. If John were to withdraw the money to spend it on anything from a car to a haircut, there are no issues. However, if the money withdrawn is subsequently invested by John in a non-registered account, then the amount invested will be attributed back to Jane, and the interest, dividends, and capital gains will be taxed at Jane’s rate.
A non-registered account cannot escape taxation, but it still may be a good account choice. Interest income will be taxed at ordinary rates. Eligible dividends will be taxed at a grossed-up rate and then be eligible for a tax credit. Capital gains are taxed at half the rate of interest income. Furthermore, the government allows you to use realized capital losses to offset realized capital gains. So, although nobody wants to lose, if you want to speculate on a high-risk investment, it may be prudent to do your speculation in a non-registered account.
While non-registered accounts can be joint, it is important to recognize that any income earned will need to be attributed to one or the other spouse or split according to a percentage that you can substantiate. If Jane and John owned a joint non-registered account, the CRA could justifiably question whether a 50/50 split is legitimate. They might do better to own separate non-registered accounts. Jane could also lend money to John to invest in his account, and charge interest to John at the prescribed rate set by the government. Currently, that is 1% but the prescribed rate is set to rise to 2% after June 30. Jane would declare the interest received from John as income, while John would write off the interest paid as an investment expense.
This does not exhaust the different types of investment accounts, but RRSPs, RRIFs, TFSAs, and non-registered accounts are the main types to be aware of. Even the non-registered account is unlikely to be used by many as few Canadians maximize both RRSPs and TFSAs. Each account type has its pros and cons; as this post has sought to point out, one of the big factors to consider in working out the choices one makes is their respective tax treatments.
This is the 150th blog post for Russ Writes, first published on 2022-05-30.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.