What goes where: Funding your registered accounts

Take advantage of tax breaks, but don't forget about growth.

Matthew Elder 1 March, 2016 | 6:00PM
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The first step toward funding a comfortable retirement is to ensure you set aside enough money each year so that your nest-egg can grow over time. Contributing as much as you can afford, up to the maximum allowable amounts each year to tax-assisted schemes such as the registered retirement savings plan (RRSP), tax-free savings account (TFSA) and registered education savings plan (RESP), is important. In addition, it's essential to hold the right types of investments in these plans -- not just for the tax advantages but also for fundamental investment reasons.

So with the 2015 RRSP contribution deadline now past, it's a good time to review the contents of your various accounts in order to take full advantage of the tax rules and to ensure your medium- and long-term financial needs can be met.

According to conventional thinking, an RRSP, TFSA or RESP should be the place to hold fully taxed investments such as cash and interest-paying securities. Stocks and equity funds -- which produce capital gains and dividends that are taxed at preferential rates -- should ideally be held in a non-registered account. But of course there are other things to consider. Among them is the need to achieve good long-term growth, particularly within an RRSP, which means also including equities.

Even before looking at the tax implications and other issues, you should first make sure that overall -- regardless of the particular account -- you are following the right strategy to suit your goals and temperament, says Peter Guay, a CFA charterholder and portfolio manager with PWL Capital Inc.

"Every investor should decide how much risk they want and can accept, which drives the balance between fixed income versus equities that should be held in their portfolio," he says. "How much growth is required to achieve your objectives? How well do you sleep at night when markets drop? If you're not comfortable making these decisions on your own, get the help of an advisor."

Once your risk level is decided, you can then look at asset allocation, Guay says. On the equity side, how much do you want in the Canadian, U.S. and international markets? And on the fixed-income side, do you want to focus on government bonds, or corporate issues?

"Only after risk and structure have been determined should you look for tax efficiency, as in where to hold the various pieces of your overall investment assets to be tax-optimal," says Guay.

Here are some basic investment-strategy guidelines for RRSPs, TFSAs and RESPs:

Use RRSPs to defer fully taxable income

With RRSPs, you invest using pre-tax dollars, thanks to tax deductions. Then, the capital grows free of tax until it is withdrawn. At that point, you pay tax on the amount you take out. This means both the capital and income portions (including realized capital gains) are taxed in the year of withdrawal.

From a tax standpoint it makes sense to hold assets that generate fully taxable income types such as cash deposits and bonds, as well as dividend-paying U.S. and other foreign stocks. However, this should not preclude the use of Canadian equities in your RRSP (as well as in your taxable account) in the name of long-term growth.

"An RRSP should be used as a long-term savings vehicle, not for short-term needs," Guay says. "Liquidity is not important, unless nearing retirement or age 71, when withdrawals (through a registered retirement income fund, or RRIF) have to start. Therefore, you can take advantage of investments that provide a liquidity premium, which is when you have a higher expected return in exchange for having to wait for the optimum time to sell. Examples of such investments might include real-return bonds and small-cap stocks."

An RRSP must be collapsed by the end of the year in which you turn 71, with the proceeds transferred to a RRIF or used to purchase a registered life annuity. The tax deferral continues with either of these options until you withdraw or receive payments.

When retirement time is drawing near, you should consider adjusting your RRSP portfolio so that it holds enough low-risk and liquid assets to provide for the initial three to five years of RRIF withdrawals, Guay says. Suitable investments might be a guaranteed investment certificate, term deposit, money-market mutual fund or a short-term government bond. By holding sufficient liquid holdings, you won't be forced to sell stocks or equity funds at a less than optimal time in order to meet withdrawal needs.

TFSAs can fund shorter-term needs

Because money can be withdrawn from a TFSA completely free of tax, this can be a good place to save for short- to medium-term goals. And if you don't need the money, it can serve as an excellent means of augmenting your retirement savings.

How you invest your TFSA assets, therefore, depends on your objectives. "Typically, we prefer to hold investments that provide a higher income in a TFSA," says Guay. "But certain income-producing investments that offer equity-like returns also may be a good choice, such as real estate investment trusts (REITs), utilities stocks and high-yield (corporate) bonds."

However, if TFSA assets are needed to meet shorter-term goals, such a down payment on a home, funding home renovations, buying a cottage or for vacations, then less risky investments with good liquidity are preferable.

Grow cautious with RESPs as college years near

There are two basic types of RESPs: self-directed individual and family plans, or scholarship plans. The latter are pools based on a beneficiary's age, to which you contribute predetermined amounts. The funds are invested by the scholarship trust, with proceeds paid out based on the value of the particular age group's asset pool.

A self-directed RESP also is an investment based on the beneficiary's education timeline, but you decide how your contributions are invested.

"Typically, the beneficiary will start withdrawing at 18 or 19 years of age," says Guay. "In his or her younger years, you can be more aggressive with the portfolio and as they approach university age, the asset mix should become more conservative to increase liquidity and decrease volatility. In many cases, an index-based balanced fund with low management fees is a good choice. You want to avoid having a portfolio of individual investments with unnecessary small transactions."

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About Author

Matthew Elder

Matthew Elder  Former Vice President, Content & Editorial of Morningstar Canada, Matthew was previously an editor and columnist at the Financial Post and The Gazette in Montreal.

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