Tax shelters in Canada that can help you save money when you use them correctly
Tax shelters in Canada aim to reduce or eliminate your tax liability.
These legal investment vehicles let investors pay less tax. Still, some are risky and should be avoided, like flow-through limited partnerships, while others, like RRSPs and TFSAs, are great ways for Canadian investors to cut their tax bills. (In the U.S., IRAs and 401ks are examples of retirement tax shelters.) Those tax shelters are closely monitored and regulated by government regulators.
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The federal government first made the tax free savings account (TFSA) available to Canadian investors in January 2009. These accounts let you earn investment income—including interest, dividends and capital gains—tax free. You could contribute $5,000 in 2009 to start your tax free savings account. The only qualification was that account holders be 18 years or older.
On January 1, 2013 the annual contribution limit increased to $5,500. It has since risen to $6,000, with the exception of 2015, when it rose to $10,000. That means that if you haven’t contributed yet (and were 18 years or older in 2009) you can now contribute up to $75,500 in 2021.
Tax-free savings accounts let you earn investment income—including interest, dividends and capital gains—tax free. But unlike a registered retirement savings plan (RRSP), contributions to TFSAs are not tax deductible. However, the withdrawals you make from a TFSA are not taxed.
The only restriction is that you can’t put the money you took out back in the same year. However, if you have sufficient unused contribution room, putting the money back won’t trigger a penalty from the Canada Revenue Agency.
Tax shelters in Canada: Registered Retirement Savings Plans (RRSPs)
You can put money in a Canadian RRSP (Registered Retirement Savings Plan) tax shelter each year (up to a limit based on your income) and deduct it from your taxable income. You only pay income tax on your investment, and the income it earns, when you make withdrawals from your RRSP.
A properly structured investment portfolio can let you take advantage of the low tax rate on capital gains and dividend income outside of your RRSP, while it shelters your higher-taxed interest income in your RRSP.
Generally speaking, it’s best to hold interest-bearing investments inside an RRSP. That’s because, of the three forms of income (interest, dividends and capital gains), interest is the highest taxed. Dividend-paying investments, and those expected to yield capital gains, are best held outside—unless you only hold dividend-paying stocks, and then they are okay to hold in your RRSP. Some investors only invest RRSP funds in interest-paying securities, because they hate to see tax advantages go to waste. However, this makes less sense when interest rates are low.
Stocks come with two key tax advantages. The dividend tax credit applies to dividends from Canadian companies, so they are worth around one-third more, after tax, than the same amount of income from interest. This advantage goes to waste in an RRSP.
If you hold dividend-paying stocks in your RRSP tax shelter, you defer taxes, but lose the dividend tax credit. When you withdraw money from your RRSP, you’ll pay taxes on those dividends at the same rate as regular income, regardless of how you earned the money. So it’s best to hold dividend-paying stocks outside your RRSP—again, unless you only hold dividend-paying stocks, and then they are okay to hold in your RRSP.
For example, Ontario investors in the highest tax bracket pay tax of around 39% on dividends, compared to 53% on interest income. Investors in the higher tax bracket pay tax on capital gains at a rate of 27%.
So, if you hold dividend-paying stocks in your RRSP tax shelters, you defer taxes, but lose the dividend tax credit. When you withdraw money from your RRSP, you’ll pay taxes at the same rate as regular income, regardless of how you earned the money. So it’s best to hold dividend-paying stocks outside your RRSP.
Tax shelters in Canada: Registered Retirement Income Funds (RRIFs)
A RRIF is a Registered Retirement Income Fund, a tax-deferred retirement plan for your Registered Retirement Saving Plan (RRSP). RRIFs are used by those who don’t plan to cash out their RRSP as a lump sum when they retire, and prefer to extend their investment and take smaller withdrawals by converting to a RRIF. Registered Retirement Income Funds offer more flexibility and tax savings than annuities or a lump-sum withdrawal.
Converting to a RRIF is the best retirement investing option for most investors. That’s because RRIFs offer more flexibility and tax savings than annuities or a lump-sum withdrawal.
Like RRSP, a RRIF can hold a range of investments. You don’t need to sell your RRSP holdings when you convert—you just transfer them to your RRIF.
When you hold a RRIF, you must withdraw a minimum each year and report that amount for tax purposes. (You may withdraw amounts above the minimum at any time.) Revenue Canada sets your minimum withdrawal for each year according to a schedule that starts at 5.28% of the RRIF’s year-end value at age 71, reaches 6.82% at age 80, and levels off at 20% at age 95.
Canadians don’t seem as interested in RRSP as they once were. What’s your current interest in RRSPs?
This article was originally published in 2017 and is regularly updated.
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