No, investing in a non-registered account doesn’t beat an RRSP

Before tax-free savings accounts came along, I invested in stock index funds in my registered retirement savings plan. Now, I realize that these investments do not benefit from favourable tax treatment available for dividends and capital gains in a non-registered account. This makes me think that on an after-tax basis it’s better to hold equities in a non-registered account than in an RRSP. Is my thinking correct?

No. It’s a myth that you’re better off holding stocks in a non-registered account to benefit from the favourable tax treatment of dividends and capital gains. The opposite is true, as I’ll demonstrate in a moment.

The key thing to understand is that the dividend tax credit and 50-per-cent inclusion rate for capital gains don’t eliminate tax. They just reduce it relative to the tax rate on interest and other income.

In an RRSP, on the other hand, there are no taxes on investment gains or income.

I can hear people objecting: “But you pay tax when you withdraw money from your RRSP!” That’s true. But what critics of RRSPs forget is that RRSP contributions are made with pre-tax dollars. When the government taxes your RRSP withdrawals, it’s basically collecting the tax it let you defer originally, plus the implied growth of that tax over time.

Let’s look at an example that compares the returns of two investors, Harry and Sally. Harry chooses to invest in a non-registered account to get the supposed tax savings on dividends and capital gains. Sally follows the conventional wisdom to invest in her RRSP. We’ll assume both investors start with $10,000 before tax and have a constant marginal tax rate of 40 per cent on regular income and 20 per cent for both dividends and capital gains. (These rates are for illustration purposes only.)

Let’s start with Harry. Because he is investing in a non-registered account, he’ll be using after-tax dollars. So, the first thing he needs to do is pay $4,000 of income tax on his $10,000. That leaves him with a net $6,000. Let’s assume he invests the money in a stock that triples in value to $18,000 and pays him $1,000 in dividends over 10 years, for a total of $19,000.

When Harry sells his shares, he’ll owe capital gains tax of $2,400 (20 per cent of $12,000). He will have also paid $200 of tax on his dividends (20 per cent of $1,000). That adds up $2,600 of tax on his investment earnings, leaving Harry with a net $16,400 after tax ($19,000 minus $2,600).

Now, let’s look at how Sally would fare if she bought the same stock in her RRSP. Because she’s investing pre-tax dollars, she gets to put the entire $10,000 into her RRSP. After 10 years, her shares will have tripled to $30,000, and she will have collected about $1,667 in dividends – about 67 per cent more than Harry. Before any taxes are deducted, Sally will have $31,667 in her RRSP.

When it’s time to cash in her shares and withdraw the money, Sally will pay income tax of about $12,667 (40 per cent of $31,667), leaving her with $19,000 after tax ($31,667 minus $12,667). That’s $2,600 more than Harry.

If that number sounds familiar, it’s because Harry paid exactly $2,600 of tax on his capital gains and dividends in his non-registered account, whereas Sally paid no taxes on her investment earnings. As this example illustrates, far from saving tax, non-registered accounts increase your taxes relative to investing in an RRSP.

To repeat, this example assumes a constant tax retirement. But if we assume a lower tax rate when money is withdrawn from an RRSP – as is the case for many retirees – Sally’s advantage would be even greater.

I sold a U.S. stock in a non-registered account for the tax loss and waited 30 days. Now, I want to repurchase the stock in my tax-free savings account. Do I have to exchange the U.S. dollars to Canadian dollars before I put the money in my TFSA, and then exchange the funds back to U.S. dollars to repurchase the U.S. stock?

Currency conversions are your enemy as an investor. Banks typically take a profit of 1 to 2 per cent each time they buy or sell, so converting U.S. dollars into Canadian dollars, and then back again, would be a double whammy. The good news is that, depending on your broker, you may be able to avoid the hassle and expense of currency switching.

There is certainly no legal reason you can’t deposit U.S. dollars directly to your tax-free savings account.

“You can contribute foreign funds to a TFSA,” the Canada Revenue Agency says on its website. “However, your issuer will convert the funds to Canadian dollars (using the exchange rate on the date of the transaction), when reporting this information to us.”

Note that the value of your U.S. dollar contribution, expressed in Canadian dollars, cannot exceed your TFSA contribution room. Overcontributions to TFSAs are subject to a penalty tax of 1 per cent per month on the excess amount.

Now, back to your question. Some brokers make it painless to contribute U.S. dollars to a registered account. For example, my broker, BMO InvestorLine, has a straightforward “move money” feature. I simply choose the account I’m moving money from, specify the currency and choose the destination account.

With some brokers, however, the process is more convoluted. TD WebBroker, for instance, says on its website that contributions cannot be made directly to the U.S. dollar component of a TFSA or registered retirement savings plan. Clients must contribute to the Canadian dollar side of their registered account, then convert the money to U.S. dollars.

Some TD clients use a workaround to avoid currency conversion costs. They purchase a U.S. money-market fund in their non-registered account using U.S. dollars, transfer the fund in-kind to the U.S. side of their registered account, then sell the fund and realize the cash proceeds in U.S. dollars.

Speak to your broker about what options are available. If your broker doesn’t allow direct TFSA contributions in U.S. dollars, ask how it can facilitate a transfer that minimizes or eliminates currency-conversion costs.

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