Biography: Wilmot is a Certified Financial Planner and Director of Tax and Estate Planning at Mackenzie Financial Services Inc.
Benefits of saving in a Tax Free Savings Account (TFSA) versus a Taxable Non Registered Account
Q: Mr. George, what are your thoughts (benefits and drawbacks) on taking on RRSP (Registered Retirement Savings Plan) loans to make contributions? Is this not a good idea for people with pre-existing debts like student debt and credit card debt?
A: This is a great question, and a tricky one to contemplate. Of course, if an individual has excess cash flow, using the cash flow to fund an RRSP or debt is, in most cases, the best way to go. However, an RRSP loan is a solution where cash flow is not readily available.
Like most things in life, there are advantages and disadvantages to receiving an RRSP loan. Some of the advantages are as follows:
i) Allows for immediate RRSP tax deduction
RRSP contributions can be of great value – especially for those at higher tax brackets. They provide tax deductions that allow one to defer tax to a time of their choosing – preferably when taxed at lower rates (eg. at retirement). If an individual does not have the money to make an RRSP contribution, an RRSP loan can provide a solution. It provides the cash flow needed to make a desired contribution and allows individuals to meet RRSP contribution deadlines they would otherwise miss.
ii) Tax deferred savings for a longer period of time
Because RRSP (Registered Retirement Savings Plan) loans allow investors to contribute to their RRSP sooner, investors are able to benefit from tax-deferred growth in the RRSP that much sooner. A key feature of the RRSP is that income and gains earned in the RRSP are not immediately taxed. The income/gains accumulate in the RRSP free of income tax until withdrawn. Because tax is not payable on the income until withdrawn, the RRSP can grow faster.
iii) RRSP contribution may create tax refund
Where tax is paid on employment income throughout the year, an RRSP contribution can create a tax refund. Employers are generally required to withhold a certain amount of tax from employee salaries in respect of income tax. If the employee makes an RRSP contribution, it effectively reduces the amount of tax that should have been paid on the employment income for that year. The government refunds the overpayment when the employee files their tax return for the year. If an employee would like to make an RRSP contribution but does not have the excess cash flow, an RRSP (Registered Retirement Savings Plan) loan can provide the necessary funds, and possibly create a tax refund. Once received, the refund can be used for any purpose, including paying down the RRSP loan.
Against these advantages, the following are some disadvantages to consider.
i) An RRSP loan must be repaid
An RRSP loan must be repaid – even if the investment purchased with the loan decreases in value. This is why it is important to work with a qualified financial advisor. A financial advisor can help an individual select appropriate investments to manage the risk associated with borrowing to invest. An advisor can also help assess an individual’s ability to repay the RSP loan and define a schedule to achieve that goal.
ii) Interest is payable on most RRSP loans
Like loans for other purposes, interest is payable on most RRSP loans. So, shopping around for a good rate is a good idea. Borrowers should keep in mind that they are on the hook to repay both principal and interest on RRSP loans.
iii) Interest not tax-deductible
Borrowing to invest in an RRSP will not permit a tax deduction for interest paid on the loan. Unlike interest paid on money borrowed to invest in non-registered investment accounts, and also interest paid on government sponsored student loans, interest paid on RRSP loans is not tax-deductible.
Whether or not an individual should take on an RRSP (Registered Retirement Savings Plan) loan is a decision that should be made based on personal circumstances. One answer does not suit all individuals. While existing debt (and the ability to pay off such debt) is a factor that should be considered, other factors such as current and future tax rates, available interest rates and RRSP contribution limits should also be considered. It is best to work with a financial advisor to determine the most suitable option.
Q: If someone had to choose between putting money into a RRSP or a TFSA, what are some of the factors that you evaluate? Are some investments more amenable to be put in TFSA’s than RRSP’s?
A: The first thing I generally consider is what the money will be used for. Is the investor expecting to use the money for short- or long-term purposes? If short-term, because of its flexibility, the TFSA (Tax Free Savings Account) is generally the better vehicle. TFSAs allow Canadians to withdraw amounts at any time for any purpose without tax, and amounts withdrawn can be re-contributed to the TFSA in any future year without using up new TFSA contribution room. This differs from the RRSP in that once an amount is contributed to an RRSP and an RRSP tax deduction is taken, if withdrawn, tax is payable on the amount withdrawn and RRSP contribution room is lost. For this reason, RRSPs are generally best used for longer term purposes.
If the money will be used for the purchase of a home or to go to school, an RRSP might be a better option for the first $25,000 of a home purchase or $20,000 of tuition fees. Because the government of Canada allows Canadians to withdraw up to $25,000 from their RRSP tax-free under the Home Buyers’ Plan (HBP) and up to $20,000 tax-free under the Lifelong Learning Plan (LLP), an RRSP is a possible funding vehicle for these expenses. Not only would the participant receive an RRSP tax deduction for the amount contributed to the RRSP, they could also withdrawal the specified amounts tax-free for the above specified purposes. Taxpayers should note though, amounts redeemed under the HBP and LLP programs must be repaid to the RRSP. If the amounts are not repaid, the outstanding amounts are generally subject to tax in the year they are due.
Another consideration is the investor’s tax rate at the time of contribution and expected tax rates at the time of sale. If an individual is at a lower tax rate today and expects to withdraw their money when at a higher tax rate (eg. maybe a new graduate saving for a car to be purchased in a few years when at a higher tax bracket), the TFSA is generally a better investment vehicle. Although there is no tax deduction for contributions to a TFSA, principal and any income or gains earned in the TFSA can be withdrawn tax-free. This avoids the taxpayer’s higher tax bracket at the time of withdrawal. On the other hand, if the taxpayer has a high income and is taxed at higher tax rates, assuming the taxpayer will withdraw the money when at a lower tax rate (eg. retirement), the RRSP is more tax-efficient. In this case, the RRSP contribution provides a tax-deduction at higher tax rates, and although amounts withdrawn from the RRSP are subject to tax, they would be taxed at lower rates in the future. This concept is discussed by way of examples in the attached slides.
See Slides Below
Q: What happens to a TFSA on death of the TFSA holder?
A: TFSA (Tax Free Savings Account) legislation allows TFSA investors to name a successor holder . The successor holder must be a spouse or common-law partner (CLP). By virtue of this designation, the successor will acquire all rights of the original TFSA investor on the investor’s death. The successor holder simply replaces the original TFSA investor, and the plan continues with all rights passing to the successor. Successor holders do not require TFSA contribution room to receive this benefit.
The naming of a successor holder is effective in ensuring that income earned after the original investor’s death is not taxed. Without a successor holder, TFSA legislation requires taxation of income earned in the TFSA after death. Consider the following example:
Allan, a TFSA investor, died with a TFSA valued at $35,000 at the time of his death. Allan’s spouse, Meg, was not named successor holder,but was entitled to his TFSA by way of his will. Six months after Allan’s death his TFSA was closed. Between the time of death and the closing of his plan, the TFSA increased by $2,000. As beneficiary of his estate, Meg received $37,000 from Allan’s TFSA, $2,000 of which was fully taxable to her as ordinary income.
Notice that $35,000 was received by Meg tax free. This represents income earned in the TFSA prior to Allan’s death – income that remains tax free when paid to beneficiaries. However, because a successor holder was not named, the $2,000 earned after death became taxable. If Meg were named successor holder of Allan’s TFSA, she would have replaced him as holder, and the $2,000 would have been earned tax-free.
Q: What if you don’t name a spouse or common-law partner to receive your TFSA at the time of your death – Would your beneficiaries require TFSA contribution room to continue to earn tax-free income after your death?
A: Generally, yes. Although the value of your TFSA (Tax Free Savings Account) at the time of your death would normally be tax-free to your beneficiaries, your beneficiaries will require TFSA contribution room to invest the full inheritance in a TFSA in their name.
Q: RRSPs and TFSAs have been well covered in the media recently. How are non-registered investments taxed?
A: Generally speaking, outside of registered plans such as RRSPs, RRIFs and TFSAs, there are three forms of investment income in Canada; interest income, dividend income and capital gains.
Interest income is taxed least efficiently. On average, across all provinces and territories, an investor at the top tax rate in Canada is taxed at roughly 44%. This means, for every $100 of interest income earned, the federal and provincial governments receive $44 total, leaving the investor with $56.
Dividends are generally taxed at a rate of roughly 23%. On $100 of eligible dividends, $23 goes to the government and $77 stays with the investor.
On average, capital gains are taxed most efficiently in Canada at a rate of roughly 22%. Therefore, $100 of capital gains income would leave the investor with $78 after tax.
Despite the above numbers, investors should keep in mind that risk levels tend to increase when investing for dividends and capital gains. Although dividends and capital gains are taxed more efficiently than interest income, it might not make sense for a risk-averse 80 year old investor who requires a steady income from her investments to invest in securities that provide primarily dividends and capital gains. For this reason, for many investors, it is very important to consult a qualified financial advisor – A financial advisor can help investors balance the scale between tax-efficiency and investment objectives.
Q: How can Mackenzie Investments help people plan and save for retirement?
A: Mackenzie will continue to work with the media to promote the importance of investment planning in the areas of investment selection, tax, retirement and estate planning. We will also continue to work closely with financial advisors by providing useful tools that can be used in discussions with clients to promote the importance of investment planning. Mackenzie Financial takes great pride in helping advance investor education.
For more information on the Mackenzie Tax-Free Savings Account, go to www.mackenziefinancial.com/tfsa, or talk to your financial advisor.
Thank You, Mr. George!
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