Wednesday, December 15, 2010

The Struggle of Tax Shelter Giants – Conclusion in plain words or is there more?

So how do all those contorted numbers of the previous posts translate in real situations? It depends on your current income and tax bracket and on how you see the future. Based on the previous posts income tax rates are likely to increase over time. Currently in Alberta , we have the following income tax brackets:
first $40,97025%
over $40,970 up to $81,94132%
over $81,941 up to $127,02136%
over $127,02139%

For a person starting out in his/her career with a salary below $40, 970 the current income tax rate is 25%. Say that person is successful and in twenty years time he/she is in the top marginal tax bracket which by then has increased to 50%. Such a person would on an after tax and after inflation basis lose money if savings were invested at a 5% in an RRSP while there would be a 1.55% profit when invested at the same interest rate through a TSFA.

A person currently in the top marginal tax bracket (a salary over $127,021) would also lose when investing through an RRSP in a 5% bearing investment but less (-0.37% versus -1.38% per year). While that person's TSFA would yield the same 1.55% per year, the same as for the first person.

If the person making less than $40,970 would remain in the same tax bracket and income tax rates would not change (i.e. stay at 25%), he/she would make both 1.55% per year on the investment when either deposited in a RRSP or a TSFA. This would also be better than not sheltering the investment.

There is one scenario where an RRSP would make you better off. That is if you expect to be in a lower tax bracket when you retire than today. Say your marginal tax rate falls from 38.8% to 25% then you will walk away with a real after tax return of 2.59% per year.

Thus for most investors it is recommended to first invest to the maximum into your TSFA and then use up your contribution room in the RRSP. Top marginal tax investors who expect that their future income tax rates are to increase should sit down with their accountants and consider whether contributing to an RRSP makes financial sense.

Over the past 20 years or so income tax rates fell and as such, people investing in an RRSP were better off, but that is likely to change as mentioned above. Also, if you invest in bonds these days, as pointed out in an earlier post, your risk of losing money has increased dramatically. That is why investing your money in a fixed income RRSP investment is not advisable right now.

On an after tax basis, dividend income is much more attractive. It is why so many investors are chasing preferred or high dividend yielding common shares. The top marginal tax rate on dividend income is right now 15.88% and next year 17.72%. Lower income earners (less than $40,970 per annum) have even a negative tax rate. So this is something one should consider for investment. Capital gains are in a very tax attractive regime as well (50% of the normal marginal tax rate). Hence, investing in the stock market, especially with the economy likely to gradually improve, is quite attractive for the near to medium (1 to 4 years) term.

Rental Real Estate has also certain tax advantages (deferred taxes on rental profits using Capital Cost Allowance plus potential tax advantaged capital gains) and with the currently depressed prices in Western Canada (Calgary and Alberta) this may be a good time to invest in this asset class as well.

Were it not that the contribution limit is low for TSFAs, it would be ideal for higher yielding stocks of good blue-chip quality. Especially international stocks, but this should always been done with a long investment time horizon – 5, 10 even better 20 years. While you collect dividends your stocks will appreciate. However, if you are like Warren Buffett and you never sell your good investments and only sell your mistakes; you will defer your capital gains taxes in non-sheltered accounts while you can recoup some of your capital losses. An investor has a lot of options and investments to choose from and what is best depends on your individual circumstances.

For us to make better informed investment decisions that provide a positive inflation adjusted after tax return, we should weigh our options carefully. In the next posts, we will continue our comparisons of after tax returns on stocks and dividends outside and inside tax sheltered accounts.

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