Wednesday, December 8, 2010

The Struggle of Tax Shelter Giants

There seems to be an eternal tug of war about whether it is better to invest into an RRSP or in a TSFA. The answer is: "It depends!"

First of all it depends on the type of investment return: Interest (fully taxed); Dividends (tax advantaged) or capital gains (50% of top margin tax rate). It also depends on the inflation rate and your annual rate of return on investment (ROI). If your ROI equals inflation both shelters break even on a after inflation and after tax basis. Those who invest for interest in a non-sheltered vehicle are the big losers. Surprisingly those investors in the lowest tax brackets lose most.

How do I know? I simulated various tax scenarios and income cases in a spreadsheet. The results truly depend on your personal circumstances. For example, the top marginal tax rate in Alberta is 38.8%. This is the lowest tax rate in decades. We seem now to be at a turning point. With increased government debt and politicians such as Obama Barack in charge we likely will see higher tax rates in the future. Say we go back to 50% tax rates; would the RRSP still be so advantageous for high income earners? Plonk, plonk the numbers are entered in my wily computerized wizard: 3.4% (historical average Canadian inflation), interest rates of 5% average) and a tax rate that changes from 38.8% to 50%, invested over 20 years.

Crunch, crunch, voila! The result is... starting with a $12,600 (maximum contribution for $70,000 annual income) you will have a RRSP tax refund of $4,888.80 and thus your real or net investment is $7,711.20. Inflating over 20 years would result in a nominal value of your net investment of $15,049.87 and... crunch, crunch... The future value of your 5% investment would have been $33,431.55. Hmmm, not bad, after 20 years your profit is $33,431.55 minus $15,0948.87 = $18,381.68! BUT it is still in your RRSP and to live of it you will have to withdraw your money! Oops, thou must pay Godzilla the Taxman!

What is your tax rate 20 years from now? The same as today? Well then you have to pay 38.8% taxes upon your withdrawal (0.388x33,431.55= $12,971.44 in taxes). The result, on an after tax and after inflation basis, is that you made $5,410 profit or a ROI of 1.55% per year By the way if you had invested that money in a TSFA your results would have been the same. If you had not sheltered your interest bearing investment your profits would have been $300.64 (obviously every penny counts) or an after inflation and after tax ROI of 0.15%.

BUT suppose the top marginal tax rate increases over time and after 20 years it is back at 50%. In that case your RRSP would have returned 0.53% annually and if the tax rate had escalated to 58% your return would have been NEGATIVE (-0.37%). At least your TSFA would have still given you the best return; it stayed the same at 1.55% (regardless of tax bracket). The real losers are those who contributed to their RRSP while NOT in the top tax bracket, say their tax bracket was only 25% when they deposited their money into their RRSP and after 20 years they ended up in the 50% tax bracket. They lost 0.49% per year.

The next posts are some images of various spreadsheets split by income groups at the top marginal tax rate (Case I) and those below (Case II). I made three runs: Average ROI before taxes and inflation of 3.4% (equalling inflation), 5% and 8%. I am sure you see why I am such a fan of the TSFA! You can now decide for your circumstances what is best for you.

If you like to have a copy of the actual spreadsheet, please, e-mail me at

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