By Harvest ETFs
Registered accounts are some of the most popular investment accounts in Canada. Broadly speaking, these accounts offer some degree of tax deferral or tax exemption for money that Canadians contribute to them. They also come with annual contribution limits. Popular examples include the Tax Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP), and the Registered Retirement Income Fund (RRIF) as well as more purpose-built accounts like the Registered Education Savings Plan (RESP), or the new First Home Savings Account (FHSA) which will launch in 2023.
All of these accounts can hold investments, and offer some kind of tax advantage.
Non-registered accounts, on the other hand, have no limits to their contributions, but also offer no special status regarding taxes. Investors can hold whatever securities they like in these accounts, but the accounts are subject to tax.
But how do these accounts work with ETF investments? And how do they work when they hold income-paying investments such as an Equity Income ETF?
The specifics of Registered Accounts
Each registered account in Canada has its own unique contribution limits and technical details.
The goal of an RRSP is to create a tax incentive for Canadians to save for retirement. Contributions to RRSPs are tax-deductible while those assets remain inside the account. Capital gains and income generated by assets held in an RRSP are also not taxed while those assets remain in the account. If money is moved outside of that account, however, it becomes subject to tax. The contribution limit is set each year at 18% of your earned income from the previous tax year up to a hard maximum amount. You can learn more about that maximum contribution here.
When an RRSP holder turns 71 their RRSP turns into an RRIF and is subject to a mandatory withdrawal schedule set by parliament. As money is withdrawn from a RRIF it becomes subject to tax. Once an RRSP becomes an RRIF the holder can no longer transfer money from a non-registered account into their RRIF. You can learn more about the challenges posed by RRIF withdrawals here.
TFSAs were introduced in 2009 as a means of encouraging savings among Canadians over the age of 18. TFSA contributions are made with after tax dollars and are not tax-deductible, but income earned by the amounts contributed as well as any gains inside it are tax-free, even when withdrawn.You can read about the TFSA contribution limit for this year here.
But how can ETFs and specifically income-paying ETFs work in these registered accounts?
How ETFs work in Registered Accounts
In order for an ETF to be eligible for a registered account, the ETF issuer must file that ETF with the Canada Revenue Agency under the tax act. In Canada that is typically done upon the launch of an ETF and most ETFs can be held inside registered accounts. Typically the ETF’s website will mention its eligibility.
The market growth opportunity that most ETFs are exposed to will take place inside the registered account. That means, in the example of an RRSP, any growth that takes place inside the account will not be subject to tax until that money is withdrawn from the account.
In a TFSA any income or capital appreciation will not be taxed when it is withdrawn
But what about income paying ETFs? Many different forms of income paying ETFs can be held in registered accounts such as fixed income ETFs, dividend ETFs, or equity income ETFs. With the exception of the TFSA, in all other registered accounts the income paid by these ETFs will not be taxed until it is withdrawn from the registered account. For fixed income ETFs and dividend ETFs the income they pay will eventually be taxed as income when it is withdrawn—Withdrawals from a TFSA are tax-free.
Generally, in the case of equity income ETFs—which use a combination of dividends and call options to generate their cash distributions—the cashflow generated by dividends will be taxed as income, but the cashflow generated with call options will be taxed as capital gains. You can learn about the efficiency of capital gains tax on cashflow here.
Registered accounts are popular for a reason. The advantages they give to investors can make a big difference when it comes to achieving your goals. It’s important, though, for investors to understand how these accounts work and how different ETFs can be used inside registered accounts.