Investing in today’s world can be daunting. With so many different investment vehicles and products to choose from – and a myriad of advisors, providers, brokers, sub-advisors, and salespeople all looking to ‘help’ us – it’s sometimes difficult to separate the value from the noise.
Moreover, the market itself often leaves cause for concern. Stock prices have gradually risen since the 2008 credit crisis, leaving many people wondering if the next bear market is around the corner.
I don’t know what the future holds. In fact, no one does – not your advisor, not the world’s leading economist, and not any politician. All we can do is build reasonable expectations of the future, based on our understanding of history and of the world today. One such expectation is that the world’s economy will continue to grow. That is why we invest – to partake in that economic growth. In doing so, we expect a positive rate of return on our investments. We can quantify that return historically, but can never predict it with perfect accuracy. All we can do is make sure our investments are balanced, diversified, and tax-efficient. That’s the first half of the battle.
When looking at return, balance, diversification, and tax efficiency, one is often undervalued. Such is the ‘second half of the battle’ – tax efficiency. I fully realize that income tax cannot exist without income, so make no mistake – tax is the tail and return is the dog (and the tail doesn’t wag the dog). However, this article will explain the importance of income tax, and the impact it has on your wealth.
To show this, let’s compare three types of investment accounts: regular (non-registered), RRSPs, and TFSAs. Registered and non-registered investment accounts have been around for a very long time. TFSAs, however, are relatively new – having been first introduced in 2009.
As you may know, investment income (interest, dividends, royalties, and realized capital gains) is taxed on an annual basis in regular investment accounts. Investment income is not taxed at all in TFSAs, and is taxed upon withdrawal from RRSPs. While I appreciate that comparing regular accounts with TFSAs is easy, comparing RRSPs with TFSAs is a little more complicated, given the tax deduction RRSPs offer when you contribute, and the taxable income inclusion you experience when you withdraw. I’ll try to zero in on this difference using some sample numbers.
Let’s assume you are a 40-year-old adult who has lived in Canada your whole life, and you have never invested before. You earn a decent living, and as such, your marginal tax rate while you are working is 45% (Tw). Your income will drop when you retire, so your tax rate in retirement will be 30% (Tr). You have never contributed to a TFSA, so you have $57,500 of cumulative TFSA contribution room (this amount has built itself gradually since TFSAs were introduced), and we’ll assume you have that same amount of RRSP contribution room. We’ll also assume you have $57,500 (I) of savings to invest.
As such, you have a choice to make – do you invest your savings into a regular account, an RRSP, or a TFSA? These days, you can hold the exact same types of investments in each type of account, so the only difference in your three choices is income tax. Let’s see which account would leave you with the most after-tax savings (S), after 25 (n) years, assuming a 6% (R) annual rate of return.
The income you earn in a regular account would be taxed annually at your applicable marginal tax rate , so your after-tax savings, after 25 years, assuming full reinvestment of your after-tax investment earnings, is calculated as follows:
Don’t get me wrong, $129,472 is a lot of money now, and will be a lot of money 25 years from now; however, let’s compare that to what you would have accumulated had you invested the same $57,500 in a TFSA. In this instance, income tax rates are irrelevant, as your annual growth could be re-invested in full and on a tax-free basis:
As you can see, you would have accumulated almost twice the wealth, had you invested the same initial funds into a TFSA. As I mentioned above, the difference between a regular account and a tax-free savings account, in terms of their ‘choice’ as a home for your investments, is a no-brainer!
Now, let’s compare a TFSA to an RRSP. The formula for calculating after-tax savings from an RRSP is a little bit more involved. The reason for this is that RRSP contributions earn you a tax deduction in the year you make the contribution. Conversely, they are fully taxable in the year you make any withdrawals. We also need to make an assumption as to what an investor might do with their tax refund. You could spend your refund, or save and invest it. If you save and invest it, you could do so within a regular account, or a TFSA. We will explore both options.
Also, RRSPs are not tax-free. Rather, they are what is termed ‘tax-deferred’. There is certainly value in that deferral – the longer you can defer paying taxes, the more money you have working for you.
Moreover, if you can defer taxation from a year where your tax rate is high (Tw = 45%) until a year when your tax rate is low (Tr = 30%), there is an inherent benefit to investing in an RRSP.
Here is a calculation of your after-tax savings, given the above example and assumptions. First, we’ll assume you invested your tax refund into a regular account:
Next, we’ll assume you invested your tax refund into a TFSA:
As you can see, RRSPs are a viable option, especially if you can ‘couple’ them with a TFSA. In the above-noted example, the reason using an RRSP (coupled with a TFSA) works out better than using strictly a TFSA is inherent in the individual’s current versus future marginal tax rates. Because the individual’s tax rate is higher now than it will be in retirement, the RRSP offers a unique multiplying effect, in that your tax refund now is higher than the taxes you will be paying later. In other words, Tw > Tr means RRSP > TFSA. Of course, the opposite could be true. Here is a basic chart, summarizing this effect.
The objective of these examples isn’t to confuse you, but to stress the importance of income tax as it relates to your investing. As you can see from the numbers noted above, income tax really is half the battle.
Balance, diversification, low fees, and the performance of the world economy all drive the bus, but income tax is probably the investment world’s biggest passenger.
Brent Soucie, Vice President & Financial Consultant
T.E. Wealth, Toronto
This article was published in T.E. Wealth’s Strategies newsletter, December 2018 edition. Read the full edition here.