The Power of Tax Advantaged Accounts

Posted by Aaron Dunn - Senior Analyst Keystone Financial

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logo mainJan 18th Media Appearance Michael Campbell’s Money Talks.

KeyStone Financial’s Senior Analyst Mr. Aaron Dunn will be speaking on Money Talks radio show with Michael Campbell (CKNW 980AM) on Saturday January 18, 2014, at after 9:00 a.m. Pacific Time. Mr. Dunn will be discussing Income Investing and Dividend Growth Stocks. For those interested in the Income Stock Research service please go to www.keystocks.com. The appearance will be archived in the CKNW (Corus Radio) audio vault on Saturday morning – the appearance should be some time after 9:00am. http://www.cknw.com/audio-vault/. It will also appear on Moneytalks.net sometime after 9am and for the balance of the week. You will find it in “The Latest Radio Show & Michael’s Market Minute”.

Market Buzz – Registered Investment Accounts – TFSAs and RRSPs 

When we talked about starting up a trading account with discount brokerage, we never specified the different types of accounts that are available. A regular trading account needs little explanation. It provides all the basic functions you need to buy, sell, and hold, stocks, bonds, and other securities. Any investment returns earned in a regular investment account are taxable as income, dividends, or capital gains. But investors also have access to a range of registered investment accounts which can provide some very attractive tax benefits. The two most common registered accounts in use are the Registered Retirement Savings Plan (RRSP) and the Tax Free Savings Account (TFSA).

Registered Retirement Savings Plan (RRSP)

The RRSP is a tax deferred account. A common misconception that many people share is that the RRSP is some type of investment. It is not. The RRSP is an investment account through which you can buy, sell and hold a wide range of different investments; just as you can in a regular account. What the RRSP does for you is allows you to contribute pre-tax income and generate returns on a tax free basis until the funds are withdrawn from the account. At withdrawal, the funds are taxed at your marginal rate for regular income. While inside the RRSP your capital can accrue returns tax deferred, which means that a portion of the return on capital you are generating actually belongs to the government (they collect their share when you make a withdrawal). One thing that is very important to understand is that when you withdraw your funds from an RRSP you do not receive the preferential capital gains tax treatment as you would in a normal, non-registered investing account. For this reason, the RRSP must be seen as a place to put capital for a long-term time horizon so it can fully benefit from the tax deferred treatment.

Basic Facts (RRSP):

• Contribution deadline March 1st.
• 2013 annual contribution limit of the lesser of $23,820 (2013) or 18% of gross income from the previous year.
• Individuals can choose self-directed (individual manages their own investments) or directed (a third party money manager administers the account).
• Unused contribution room can be carried over to future years.
• Withdraws from the RRSP are treated as income for the current year and taxed at the normal rate.
• Withdraws from the RRSP count as income and effect taxable benefits like OAS, CPP, and medical.

Tax Free Savings Accounts (TFSAs)

The TFSA is a tax free investment account. This means that you contribute money that you have already paid tax on but your investment returns on that capital accrue tax free. Just like the RRSP, you can hold a wide variety of stocks, bonds, cash instruments and alternative investments in your TFSA. One thing that people like about the TFSA is the flexibility. Investors can make deposits (up to the contribution limit) and withdraws at any time in the year with no impact to their taxable income or taxable benefits.

Basic Facts (TFSA):

• Contributions can be made at any time of the year.
• Annual contribution limit of $5,500 (2013) with ongoing inflation increases in increments of $500.
• Individuals can choose self-directed (individual manages their own investments) or directed (a third party money manager administers the account).
• Unused contribution room can be carried over to future years.
• Withdraws from the TFSA do not count as income and are not taxable.
• Withdraws from the TFSA do not effect taxable benefits like OAS, CPP, and medical.

The Power of Tax Advantaged Accounts

To illustrate how powerful these registered accounts can be we will use a simple example. We have three fictitious investors John, Jim, and Mary. Each has made an extra $5,000 in pre-tax income for the year that they wish to invest. John invests in a regular investing account, Jim uses his RRSP and Mary uses her TFSA. All three investors have a marginal tax rate of 30% and will each earn an average pre-tax return of 8% over the following 10 years.

John (Regular Investing Account): The regular investing account provides no special tax benefits and John must first pay tax on his $5,000 of income before he can deposit it into his account.

After Tax Contribution = $5,000 x (1 – 30%) = $3,500

John must also pay tax on his investment returns. We are assuming that the portfolio is taxed on an annual basis at a marginal rate of 35% (in reality it is a little more complicated).

After Tax Return = 8% x (1 – 30%) = 5.6%

After 10 years, the $3,500 after tax contribution will be worth $6,035.

$6,035 = $3,500 x (1 + 0.056)10

Jim (RRSP): The RRSP allows Jim to invest his income on a pre-tax basis so he retains the entire $5,000 as his initial contribution. The RRSP also allows investment returns to accrue tax deferred as long as they remain in the account.

Initial Contribution = $5,000

Annual Return on Investment = 8%

After 10 years, the $5,000 after tax contribution will be worth: 

$10,795 = $5,000 x (1 + 0.08)10

But before Jim can run off with his money, he has to remember the tax. RRSPs are a tax deferred account but the bill must be paid upon withdrawal. The after-tax value of the portfolio base on the 30% tax rate will be $7,556.

$7,556 = $10,795 x (1 – 30%)

Mary (TFSA): The TFSA allows Mary to accrue investment returns tax free but the contributions are made with after tax dollars.

After Tax Contribution = $5,000 x (1 – 30%) = $3,500

Annual Return on Investment = 8%

After 10 years, the $3,500 after tax contribution will be worth $7,556.

$7,556 = $5,000 x (1 + 0.08)10

Because tax was already paid on the initial contribution and the returns accrue tax free, the capital can be withdrawn from the account at any time without any impact on taxable income.

RRSP vs. TFSA

You have probably noticed that in our last example both the RRSP and the TFSA generated the exact same portfolio value at the end of the 10 years. That is because we assumed the same tax rate at contribution and withdrawal. With the TFSA you pay the tax today. With the RRSP you pay the tax when you withdraw the funds. The most effective alternative is the account that pays the lowest tax rate. If your tax rate is lower today, the TFSA is the more attractive option. If your tax rate will be lower when you withdraw the funds 10 or 20 years from now, the RRSP is more attractive option. Although most of us will assume that our tax rate at retirement will be lower than in our peak earning years, the fact of the matter is that the future tax rate is unknown. We don’t know what the tax rate is going to be a decade or two in the future. What is more important than spending too much time deliberating between the TFSA and RRSP is that you make use of at least one of these tax advantaged vehicles. A lot of people like the TFSA due to its flexibility. Contributions and withdrawal (and then re-contributions) can be made at any point in the year (up to the respective contribution limits) with no impact on taxable income or taxable benefits. 


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Regards,

Jenny McConnell,

Administrative Assistant/Office Manager