Anyone over 17 should maximize their TFSA and RRSP contributions

(Last Updated On: March 19, 2017)

Wait a second. The question is invest in one or the other. You can’t answer “yes”! You have to pick one or the other. Well I disagree. Here is a recent event which hopefully explains why anyone over 17 should maximize their TFSA and RRSP contributions.

I recently received a call from a friend asking if he had any suggestions as to a company in which one of his sons could invest a bit of money he had saved. He indicated his son had purchased Nike (NYSE: NKE) shares a few years ago and had sold the shares within the past few months because the value had increased. I couldn’t help but ask as to the rationale for the sale to begin with since my friend and his son indicated the intent was to invest these funds for the long-term. There really was no sound rationale for the sale other than the value had increased slightly from the time of the original purchase.

Given that Nike is a solid company and the fundamentals had certainly not deteriorated subsequent to the date of his original purchase, I asked whether he would consider purchasing Nike again. The answer was “Yes”. Problem solved ….or so my friend thought.

I asked in what type of account these Nike shares were intended to be held. My friend indicated his son’s salary was relatively low so the tax benefit of investing in Nike within a Registered Retirement Savings Plan (RRSP) would be negligible. He suggested that his son hold the Nike shares within a Tax-Free Savings Accounts (TFSA).

I suggested this might not be the optimal strategy. Since dividends from U.S. stocks are subject to a 15% withholding tax if held within TFSA, Registered Disability Savings Plans (RDSPs) and Registered Education Savings Plans (RESPs), it would be best that the Nike shares be held in a RRSP where U.S. stock dividends are exempt from the 15% U.S. withholding tax as per a tax treaty between Canada and the U.S.. Please note that this does not apply for American Deposit Receipts (ADRs) which are a negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock traded on a U.S. exchange. The following website lists foreign ADRs.

Foreign ADRs List

NOTE: The same 15% U.S. withholding tax exemption applies to U.S. stock dividends received within a Registered Retirement Income Fund (RRIF), a Locked-in Retirement Account (LIRA), a Life Income Fund (LIF) and a Locked-in Retirement Income Fund (LRIF) because they are also considered “retirement” accounts.

Recognizing the importance of deferring taxes as long as possible I suggested my friend’s son maximize his TFSA AND his RRSP contributions. Currently his son has insufficient funds to do both but if he were to obtain authorization from the Canada Revenue Agency (CRA) to have his employer reduce the amount deducted at source, his net pay per pay period would increase.

He could then immediately acquire the Nike shares through a self-directed RRSP. This way he is well on his way to maximizing his RRSP contribution as he stated he would and he won’t be scrambling to make sure he fulfills his end of the bargain; CRA is unlikely to provide authorization in the future if you don’t end up maximizing your RRSP contribution as stated when you applied for this concession. The increase in net pay would then be directed to the TFSA to acquire shares of a Canadian listed company so as to avoid withholding taxes.

If this strategy appeals to you, you can obtain the appropriate form to commence the process to obtain CRA’s approval to have your employer reduced the amount deducted at source.

Canada Revenue Agency – T1213 Request to Reduce Tax Deductions at Source

Please note this authorization does not go on in perpetuity. You must reapply every year.

A word of caution. If you are accustomed to receiving a tax refund after having submitted your tax return every year, the likelihood of receiving a tax refund will be substantially diminished by reason of this strategy. This is a good thing! When you receive a tax refund you have provided the government with an interest free loan. The government is not giving you money out of the goodness of its heart but is merely returning your money to you. This is why it is imperative that you direct this additional net pay toward the maximization of your RRSP contribution.

I recognize some of you are of the opinion that it would be best not to contribute to a RRSP if you are currently in a relatively low tax bracket. In other words, let the RRSP contribution room accumulate and when your career progresses and you are in a higher tax bracket you then make your “catch up” RRSP contributions. Although this makes sense in theory, I have noticed that in reality this strategy frequently does not make sense. Here is why.

As you mature and your career progresses you may purchase a car or two. You may possibly purchase a house. With a house comes mortgage payments, property taxes, utilities, maintenance, etc. Let’s not forget that your income taxes increases. You might have a child or children. Guess what? It costs a lot of money to raise a child. What if one spouse decides to stay at home to raise the child? What about possible job loss?

So while your income might increase, you suddenly have all these additional financial obligations. Sometimes it might feel like you have more month than money. If that is the case, just making your annual RRSP and TFSA contributions may end up being a challenge.

Where are you going to find the money to use up the RRSP contribution limits you have accumulated? RRSP catch up loans as advertised by the banks? While this might for work for some people, circumstances have to be just right. What if they are not right for you?

I hope you found this post to be of value and welcome your feedback.