Students of the investing course frequently ask me which investments to hold in an RRSP vs a TFSA vs their taxable accounts (i.e. their non-registered accounts). More specifically, we are referring to which ETF to hold in each account to maximize the tax efficiency that you receive.
This guide will take you through what I suggest (and what I personally do and have done in the past).
Just to set the groundwork, you typically want to max out your TFSA and RRSP contribution room before investing in a taxable account (also known as a non-registered account or “margin accounts” in Questrade).
Therefore, we’re going to start with describing what goes into the RRSP vs the TFSA first. Later in this article, I’ll explain how things change once you have maxed out both account types, and need to start investing in a taxable account too.
When deciding what investments to hold in each account, it’s best to think of having two options:
Option 1: Having all of your equities (stock ETFs) split evenly between your RRSP and TFSA.
This method is easier, it’s what I started with when I first started investing, and it’s the method that I would recommend if you’re just getting started and/or if your investment portfolio is less than $100,000.
Once your portfolio exceeds $100,000 you could then consider switching to option 2 (which I describe later in this article).
Keep in mind that technically you don’t ever have to switch to option 2 as it is more labour intensive. But, the upside is that you end up saving money on withholding taxes when they are in the correct accounts, and once your RRSP and TFSA are maxed out, you can also save a substantial amount of income tax when having the right ETFs in your taxable accounts.
In my opinion, it’s not really worth doing option two if your portfolio is under $100,000 since when you do receive savings, it’s generally a percentage of your portfolio so the amount saved can actually be somewhat negligible if your portfolio is small enough.
For example:
If you save something like 0.25% on a $1,000,000 portfolio when you do these optimizations, then that’s $2,500 per year in savings. That’s a pretty significant amount of savings, making it worthwhile for you to take that extra effort and optimize.
Also keep in mind that every dollar you save like this stays invested, meaning it will compound. So, you aren’t just saving that amount per year (the $2,500 in this example), but are also receiving dividends and capital gains on that amount as it stays invested.
However, if your portfolio is $60,000, then that only equates to a savings of $150 per year. Is that now worth your time?
It’s a personal preference and the $100,000 threshold is completely subjective. You could do option 2 whenever you want, but I definitely don’t recommend doing it if you are just getting started in DIY investing. There are enough concepts to wrap your head around when you’re first starting, so you don’t need this additional layer of complexity unless your portfolio is already on the larger side.
Okay, so let’s talk about option 1:
For all your equity ETFs (i.e. The stock portion of your portfolio), you can split them evenly between your TFSA and RRSP.
This way, both of your accounts have some Canadian stocks, some US stocks, and some international.
This makes rebalancing easier, and it’s just generally a good practice to have a variety of investments in each account as it can make things easier when you want to withdraw funds in retirement.
What account should your bond ETF go into?
For your bond ETFs, it’s generally best to keep them in your RRSP.
A key reason for this, is that your investments grow tax-free in your TFSA.
Since this is the case, you want the investments that are most likely to grow the most, in your TFSA.
Stocks have historically outperformed bonds in terms of the returns that they generate for investors. Therefore, you want those higher return assets in an account where you won’t be taxed no matter how high they grow (i.e. Put them in your TFSA).
A real-life example:
For years, what we did is split all our investments evenly between the RRSP and TFSA.
For example, we did 1/3 in Canada, 1/3 in US and 1/3 in international.
Because we were younger and had a high risk tolerance, we did not purchase any bond ETFs.
Therefore in our TFSA, if we had $10,000 to invest, we would just split it evenly.
We would do the same for the RRSP.
This worked well for years until our portfolio got much larger, especially after we sold our rental property. At that point, with the influx of cash from the sale, I transitioned to option 2 to further optimize for tax savings.
Aside: For our international portion, I did 10% in emerging markets and 22.33% in developed international. Adding this up results in 1/3 international. More details are in the course.
Option 2: The More Tax Efficient, But Also More Complicated Approach
Ok, here’s the more complicated (but also more tax-efficient process):
Once our portfolio was large enough to make this worthwhile, the big thing I did is used a technique called Norbert’s Gambit in our RRSP.
This converted Canadian currency to US currency very cheaply, which allowed us to buy the ETF with the ticker VTI in our RRSP.
Why do this?
VTI is the Vanguard Total US Stock Market ETF. It’s comparable to holding VUN in Canada.
The big difference is that VTI is traded on the US exchange in US currency (hence us needing US dollars to buy it).
Sounds like a hassle and more complicated right?
Very true. But…
By holding VTI instead of something like VUN or VFV in our RRSP, we are able to bypass the withholding taxes that get taken off from the dividends that those ETFs generate.
VTI also has lower fees (i.e. Its MER is slightly lower to comparable ETFs in Canada).
Should you hold US ETFs in your RRSP?
You may have heard from sources online that you should hold your US equity ETFs in an RRSP as it’s more tax efficient. True, but there is a caveat:
You can’t just hold any ETF that represents the US market to get this benefit.
A common mistake that some Canadian investors make is that they think they can just hold something like VUN or VFV in their RRSP and they’re done and fully optimized.
This would be ideal since VUN or VFV can be easily bought with Canadian currency on the Canadian exchange (i.e. no need to complicate things with Norbert’s Gambit) .
Unfortunately, it doesn’t work that way.
So, if you really want to bypass this withholding tax, what I’ve explained above is the most efficient way to do it (i.e. Using Norbert’s Gambit to convert the currency in your RRSP and using it to buy an ETF like VTI). This is what I have personally done in my investment portfolio.
Keep in mind that it’s likely not worth your time to do the currency conversion using Norbert’s Gambit unless you’re converting at least $10,000, as there are trading costs involved with doing it, making it not worthwhile for smaller transactions. Justin Bender from PWL Capital actually crunched the numbers on this and found that at a $20,000 conversion, it would take the conversion savings 1 year to recoup the costs. Therefore at $10,000 it would take 2 years, which I think is a reasonable amount of time since you’ll be investing for decades to come.
Also, if you really want to dive deep into the mechanics of withholding taxes (which is what heavily impacts which ETF goes into which account), then check out Justin and Dan’s guide on this here. It’s very good but you may have to read it a few times (as I did) to fully wrap your head around it as it’s definitely a pretty complex topic.
Regarding Norbert’s Gambit, you can the instructions on how to do it properly here: How to do Norbert’s Gambit
When you read about it, it will sound scary (at least it did for me and it took me years to feel comfortable enough to do it).
So, you can go down that path, or you can just keep things simple and go with option 1 that I explained above.
Then, once your portfolio is larger, and once you’ve been investing for a while and feel very comfortable with the process, then if you want you can consider option 2 with Norbert’s Gambit.
I hope that helps.
Optimizing Your International Exposure Outside Canada and the US (for example, the ETFs: XEC and XEF):
If you’re looking to fully optimize, you can have those in the TFSA since your RRSP room is being taken up by your bond allocation (if any), and your US allocation (through a US listed ETF like VTI for example to avoid the withholding tax on the dividends).
Once you have your TFSA and RRSP maxed out, then you graduate to the next level of optimization that you can do as now you have to decide what to keep in your taxable account vs your TFSA vs your RRSP.
Optimizing Your Taxable Accounts:
When you reach this level/milestone, congratulations! Very few Canadians have both of these accounts maxed out so you REALLY deserve a pat on the back for your diligent saving, and you are likely well on your way towards an early retirement.
At this point, I would still keep your US and bonds in the RRSP (for the reasons mentioned earlier), but then the next layer of complexity is deciding what goes in your TFSA vs your taxable account. Typically, Canadian index ETFs (like XIC) are taxed very favourably in a taxable account. Hence, as a general rule, once your TFSA and RRSP is maxed out, you can:
- Hold your Canadian equity ETFs in your taxable account (to get the dividend tax credit)
- Use your TFSA to hold international ETFs (i.e. Not Canada or the US) such as XEC and XEF for example.
- Use your RRSP to hold the bonds and US listed equity ETFs like VTI for example.
In practice, what happens is you may have some overflow. For instance in our case, our RRSP was maxed out with US equities and we still wanted more US equity (as per our desired asset allocation). So, in that case, I just bought a Canadian ETF representing the US market (like VUN), and put that in the TFSA to get the tax free growth.
Why did I do this? There is no tax savings for holding a US listed ETF like VTI in the TFSA vs a Canadian listed ETF like VUN, so it doesn’t make sense to go through the trouble and costs of converting currency to buy VTI like you did in the RRSP, since you won’t get that same benefit when holding that ETF in the TFSA.
What if you want to optimize but aren’t ready to do Norbert’s Gambit yet?
What if you want things optimized but not to the point where you have to start dealing with exchanging currency using Norbert’s Gambit?
The question that you have to ask yourself in this case is “Can you see yourself doing Norbert’s Gambit in the future because your portfolio has gotten pretty large and so financially, it’s totally worth doing it for the long term tax savings?”
If your answer is “no” because you never want to have to deal with that level of complexity then you might as well hold as much of your US equities as possible in your TFSA. The reason for this is that historically US equities have generated the most growth vs the rest of the world. While there is no guarantee that this will continue forever into the future I think it’s reasonable to anticipate the strong growth continuing and so you might as well keep your US equities in your TFSA as that’s the only account at your disposable where all those gains will be tax-free.
If you answer is “maybe” or “yes”: Realistically, I think most people would be willing to eventually do Norbert Gambit once their portfolio size has grown to higher levels. Also at that time, you have been investing for several years where a technique like this is no longer as intimidating.
In this case, you can buy your US equities within your RRSP but you would use an ETF that’s listed on the Canadian stock exchange. For example, you would buy VUN and while you won’t save on the withholding taxes as you would if you bought VTI (the US listed version of that using US currency), you are still doing okay because the money is still in your RRSP and so you are still getting a major tax advantage by being able to invest using your pre-tax money.
Eventually, your US equity holding like VUN will get substantial and at that point you will have an increasingly larger incentive to convert it to VTI to save money on the taxes.
To summarize, for most people just getting started with DIY investing you might as well still keep your US equities in your RRSP together with your bonds.
Then when your US holdings get substantial (for example, somewhere in the six figures), then at that point you switch them over to something like VTI to get that extra bit of tax savings.
This is what we did with our personal portfolio. I didn’t feel comfortable doing Norbert’s Gambit until I was already several years into investing. Eventually though, we sold our rental property and had a big chunk of money to invest. At that point, our US holdings were fairly large and so it was at that time that we switched over to VTI in our RRSP.
Did you find the explanations in this guide clear or would you like me to clarify anything? Feel free to let me know in the comments below and I can continue expanding this guide to increase its clarity even further if needed.
Closing Thoughts:
As you can see, it does get pretty complicated once you are forced to use taxable accounts because your RRSP and TFSA are maxed out. Keep in mind too that ideally, you’re are working with a good fee for service financial planner and accountant that can help you with this further based on your tax situation.
Realistically, if you are wealthy enough to have your RRSP and TFSA maxed out, then it makes sense to pay for a good fee for service financial planner that can optimize and model everything out based on your specific situation, as there may be certain nuances for you specifically that should be factored into your financial plan.
This guide was meant for students of the Investing Course who already have a background on a lot of these concepts after going through the investing training videos that I created in the course. If you are not currently taking the course, feel free to try it risk free here as it will clarify the different elements that I talked about in this guide.
Kornel
Appendix: Should I prioritize XEC or XEF in my taxable accounts vs the TFSA?
The following won’t impact most people, unless you are maxed out in your TFSA and RRSP, are using the same or similar ETFs that I’m using, and have a similar situation to us in terms of your asset allocation. Feel free to ignore this part unless you are part of the minority that this applies to.
I personally prioritize XEC (international emerging markets) over XEF (international developed) in my taxable account, as at the time of this writing, my calculations showed that this action would generate a slightly lower tax drag.
However, there is no easy golden rule for this as the right answer can vary depending on what the yield (the dividends) end up being for each of these. We also have no certain way of knowing which of these will perform better for the decades to come. If we knew that one will significantly outperform the other, then we would prioritize that one in our TFSA as all the growth would be tax-free.
The other element that further complicates things is that the more dividends any one of these ETFs generate, the more you are incentivised to keep it in your taxable account (to get the larger tax credit).
The bottom line is that I wouldn’t sweat over this too much. This is very much a fine tuning element that typically only applies to people that have their RRSPs and TFSAs maxed out, so don’t let this give you paralysis analysis.
In practice, here is how this applies to my own portfolio:
- Our TFSAs and RRSPs are maxed out, so I have some XEF and XEC in the taxable accounts.
- Every year, our TFSA contribution room goes up which allows me to move some money from our taxable accounts, to our TFSA.
- First, I prioritize topping up our TFSA with a US index ETF like VUN. However, in some years when rebalancing, I may already be at my desired weight for US equities and I may not have any VUN in my taxable accounts to move into the TFSA (i.e. all my US exposure is already in my RRSP and TFSA so I can’t move any more over).
- At this point, I have to choose what should go into my TFSA. It won’t be my XIC (Canadian index) as that is taxed favourably in the taxable account. So, the choice is I have to pick XEC or XEF. In this very specific/niche scenario, I would choose to move XEF to the TFSA due to the lower tax drag (hopefully).
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