A New Way to Beat the Tax Man

New opportunities require investors to re-evaluate conventional wisdom. While Canadians are often encouraged to maximize their RRSP contributions, the Conservative government has recently offered taxpayers a new, innovative investment vehicle. Harper et al. proposed a tax-free savings account (“TFSA”) as a part of the 2008 federal budget. This new initiative will probably cause the largest change in personal investing strategies since the RRSP and pension contribution limit reforms in 1991.

According to the proposed TFSA, taxpayers over the age of 18 can contribute up to $5,000 per year to their account (unused contribution room can be carried forward indefinitely). The TFSA, like an RRSP, isn’t an investment in itself; rather, it is a vehicle for holding investments (i.e., stocks, bonds). Taxpayers will not receive a deduction for contributions to the TFSA; however, all capital and income can be withdrawn tax-free at any time. (The other major personal investment vehicle, the RRSP, generally functions the opposite way. In an RRSP, all contributions (the lesser of 18% of the taxpayer’s earned income and the annual contribution limit ($19,000 in 2008)) are deductible, but all withdrawals (minus a few specific exceptions) are taxed as normal income). Clearly, both plans have distinct advantages and disadvantages from a tax perspective. There’s a trade-off between immediate tax savings in an RRSP and non-taxable future withdrawals in a TFSA.

The Issue

Though specific contribution limits exist, most working adults will be able to contribute to both plans starting in 2009. Given that most investors have limited disposable income, it’s important to determine which plan contributions should be made to first. The answer, of course, depends on several assumptions.

Components

It is important to analyze each component of the RRSP and TFSA. From a financial planning perspective, the RRSP has three components: tax savings on initial contributions, tax-free growth on funds retained in the plan, and future taxes payable upon withdrawals from the plan. All amounts that occur in the future (the latter two components) will be discounted to present value, using a 5% premium. The TFSA also provides tax-free growth on funds retained in the account, but there are no other tax consequences. Therefore the net present value of each investment vehicle is:

RRSP = Initial tax savings + PV of Investment – PV of Future Tax on Investment

TFSA = PV of Investment

PV of investment: The present value of a specific investment will be the same regardless of whether it is held in an RRSP or TFSA—it grows tax-free regardless of in which account it is retained. Therefore, as long as the initial tax savings exceed the PV of future tax on the investment, RRSP contributions should be maximized. Conversely, TFSA contributions should be maximized when the PV of future taxes exceeds the initial RRSP tax savings (since the TFSA avoids both of these tax components).

Initial tax savings: Affluent Canadians can have a personal tax rate of up 46.41% (Ontario – 2008). A $1,000 investment in an RRSP will provide $464 in immediate savings. (This benefit will be smaller for Canadians who are in a lower tax bracket).

PV of Future Tax on Investment: The present value of future taxes equals the expected future value of the investment portfolio multiplied by the expected future tax rate. I will assume that the future tax rate is 25.0%; it is generally realistic to expect people to have a lower tax rate when making RRSP withdrawals (usually during retirement), compared to when they make contributions (usually during their working life).

Scenario Analysis

Instead of making a broad generalization, I will consider investments of varying lengths and expected returns. A ten-year horizon is reasonable for investors in their mid- to late-fifties, while a thirty-year horizon (and beyond) is appropriate for young taxpayers starting their careers. A 4% expected return is conservative and is consistent with high-quality, medium-term bonds and GICs; a 12% expected return is aggressive and is consistent with small-cap stocks and foreign indices.

For example, an investor in the highest tax bracket who contributes $1,000 to an RRSP will receive an immediate $464 in tax savings. If the investment grows tax-free at 8% for twenty years, the investment will be worth $4,661; assuming a marginal tax rate of 25.0%, the investor will have to pay $1,165 in taxes when withdrawing the funds. Discounted to the present at 5%, these taxes cost $439 today. Therefore, the investor saves $464 immediately but will have to pay $439 in future taxes (in today’s dollars). Thus the investor will keep $25 by investing in the RRSP, so it is preferable to the TFSA. (In other words, the tax consequences of an RRSP are favourable, because the investors saves $25 in today’s dollars. Funds retained in both the RRSP and TFSA grow at the same rate, so we only need to focus on the PV of the tax consequences when comparing the two investment vehicles).

The table below shows the tax consequences for using an RRSP (immediate RRSP deduction minus the present value of future taxes payables). A positive present value means that the immediate savings of an RRSP contribution will offset any future taxes. A negative value means that the RRSP has a negative tax cost and a TFSA, with no tax deductions or liabilities, would be more beneficial.


Conclusions

Clearly, the RRSP is preferable to the TFSA for short-term and/or low-return investments. This makes sense because investments of that nature would grow by a relatively small amount, resulting in a small future tax liability. Thus, the present value of the immediate tax savings would exceed the future taxes payable for low-growth investments, so the RRSP is advantageous. Conversely, long-term and/or aggressive investments would grow exponentially, resulting in a large future tax liability. Since the immediate RRSP tax deduction would be small in comparison to the future tax liability, the TFSA account would be preferable. This is a very broad generalization, of course.

It is important to note that even when a TFSA is better than an RRSP, it is almost always better to hold investments in the RRSP than outside any tax-sheltered account (and vice-versa). Tax-sheltered growth is always preferable to standard, non-sheltered investments. If an investor determines that the tax-free savings account is superior, they should maximize the TFSA first, then the RRSP, before holding any investments in a non-sheltered account (and vice-versa if the RRSP is optimal).

Keep in mind that the assumed tax rates (46.4% initially, 25.0% upon withdrawal) materially impact these calculations. For example, young investors who are in a low tax bracket would almost always be in a superior position maximizing their TFSA contributions. Due to their low marginal tax rate, the RRSP deduction would be nearly worthless. Similarly, affluent investors who expect to be in the highest marginal tax rate during their entire lives would also be better off maximizing their TFSA contributions. The tax on future RRSP withdrawals would likely be prohibitively high in the top tax bracket.

There isn’t a “right answer” when choosing between the RRSP and TFSA. Although I’ve highlighted some basic strategies, it’s important to carefully consider all relevant variables that apply. Let’s thank the Conservatives for giving Canadians this important new savings opportunity.