First thing I would like to indicate is that the TFSA is supposed to be a mirror image of an RRSP. The two plans are designed to produce the same results. Lets take a look at some of the details of the TFSA.
Pros
- Tax-Free Growth
- Tax-Free withdrawals
- Can withdraw at any time
- Unused balance gets carried forward indefinitely
- Any amount withdrawn gets added to next years contribution limit
- Anybody over 18 with a SIN card can open (does not matter about previous years income, as it would with RRSP)
- No age limit for contributions
- Withdrawals and earnings do not affect government programs such as OAS
- Can contribute in spouse's name without the spouse having to report income
- Transfers to spouse on a tax-free basis upon death (when RRSP transfers to spouse upon death it is also tax-free, but spouse must pay taxes upon withdrawal)
Cons
- Contribution limit
- No tax deductions
- Investing with after-tax dollars
- Cannot re-contribute amount withdrawn until next calendar year
- 1% penalty per month on amount that is over contribution limit
- Cannot be joint or spousal
Many investors were also weary of investing into an RRSP because of the tax consequences upon withdrawal, so the TFSA was started as something to complement the RRSP, and not necessarily compete with it. That being said, there are certain circumstances where one is better then the other. One way of utilizing both vehicles at the same time is by using the money received as the tax refund to fund the TFSA (the same strategy can be used from the tax refund received from an investment loan).
Essentially, I believe the TFSA should be a compliment to either the RRSP, the Non-Registerd vehicle, or both! Lets look at an example of using only TFSA, and using RRSP and TFSA together.
Assumptions:
Annual Pre-Tax Contribution: $5,000
Rate of Return: 8%
Marginal Tax Rate: 40%
Length of Investment (Years): 20
Option #1: TFSA
Total After-Tax Contribution: $60,000.00 ([$5000 x 0.6] x 20 years)
Total Account Value after 20 years: $137,285.89
Net Benefit of Strategy (Growth): $77,285.89
Option #2: RRSP
Total Contribution (Pre-Tax): $100,000
Total Account Value after 20 years: $228,809.82
Net After-Tax Value (40% Tax Rate): $228,809.82 x 0.60 = $137,285.89
As you can see, the after-tax value for both the TFSA and the RRSP are the exact same. This is to prove that the TFSA is designed as a mirror image of the RRSP, because (usually) the money invested into a TFSA is after-tax dollars, whereas the money invested into an RRSP is pre-tax dollar. Let's take a look at using both strategies together.
Option 3: RRSP with TFSA
Total Contributions to RRSP: $100,000
Annual Tax Refund: $2,000 ($5000 x 0.40)
Total Account Value of RRSP after 20 years: $228,809.82
Net After-Tax Value (40% Tax Rate): $228,809.82 x 0.60 = $137,285.89
Tax Refunds invested every year in TFSA: $2,000
Total Contribution to TFSA (20 years): $40,000
Total Account Value of TFSA after 20 years: $91,523.93
Total Combined after-tax Value of the RRSP and TFSA: $137,285.89 + $91,523.93 = $228,809.82
As you can see, using both strategies together results in maximum account value. By using both strategies together, the result is the same as if you were to negate any taxes on the RRSP. So, in essence, both strategies can be benficial.
That being said, in some cases, one strategy is better then the other:
1. If your Marginal Tax Rate is higher at the time of contribution, then the RRSP strategy would make a better choice, because a) you will recieve a larger tax refund, and b) when you withdraw from your RRSP later down the road, you will pay less in taxes.
2. If your Marginal Tax Rate is higher at the time of withdrawal, then the TFSA strategy will be a better choice, because a) when the funds are invested, they are done so with more after-tax dollars, and b) when the funds are withdrawn, they are tax-free.
Lastly, I would like to discuss the investment of funds that are not taxed. For example, we might get a bunch of money for our birthdays, weddings, or just from loving grandparents. These gifts are rarely declared on taxes. Also, there are some professions that work on a cash basis (i.e. taxi drivers, some truck drivers, some labour jobs etc...). In these sort of situations where the cash is not being taxed, then the TFSA will definitely be a better strategy, since the taxation on the invested money is 0. Please note, I think paying taxes is very important, and I am not suggesting that we all try to hide income from the CRA. I think every citizen should pay their share of taxes (but not a penny more!).
Just as every other strategy, this isn't the be-all, end-all of investing. And as well as all other strategies, please consult your financial advisor and do your own homework. If you have any questions, please do not hesitate to contact me!
Essentially, I believe the TFSA should be a compliment to either the RRSP, the Non-Registerd vehicle, or both! Lets look at an example of using only TFSA, and using RRSP and TFSA together.
Assumptions:
Annual Pre-Tax Contribution: $5,000
Rate of Return: 8%
Marginal Tax Rate: 40%
Length of Investment (Years): 20
Option #1: TFSA
Total After-Tax Contribution: $60,000.00 ([$5000 x 0.6] x 20 years)
Total Account Value after 20 years: $137,285.89
Net Benefit of Strategy (Growth): $77,285.89
Option #2: RRSP
Total Contribution (Pre-Tax): $100,000
Total Account Value after 20 years: $228,809.82
Net After-Tax Value (40% Tax Rate): $228,809.82 x 0.60 = $137,285.89
As you can see, the after-tax value for both the TFSA and the RRSP are the exact same. This is to prove that the TFSA is designed as a mirror image of the RRSP, because (usually) the money invested into a TFSA is after-tax dollars, whereas the money invested into an RRSP is pre-tax dollar. Let's take a look at using both strategies together.
Option 3: RRSP with TFSA
Total Contributions to RRSP: $100,000
Annual Tax Refund: $2,000 ($5000 x 0.40)
Total Account Value of RRSP after 20 years: $228,809.82
Net After-Tax Value (40% Tax Rate): $228,809.82 x 0.60 = $137,285.89
Tax Refunds invested every year in TFSA: $2,000
Total Contribution to TFSA (20 years): $40,000
Total Account Value of TFSA after 20 years: $91,523.93
Total Combined after-tax Value of the RRSP and TFSA: $137,285.89 + $91,523.93 = $228,809.82
As you can see, using both strategies together results in maximum account value. By using both strategies together, the result is the same as if you were to negate any taxes on the RRSP. So, in essence, both strategies can be benficial.
That being said, in some cases, one strategy is better then the other:
1. If your Marginal Tax Rate is higher at the time of contribution, then the RRSP strategy would make a better choice, because a) you will recieve a larger tax refund, and b) when you withdraw from your RRSP later down the road, you will pay less in taxes.
2. If your Marginal Tax Rate is higher at the time of withdrawal, then the TFSA strategy will be a better choice, because a) when the funds are invested, they are done so with more after-tax dollars, and b) when the funds are withdrawn, they are tax-free.
Lastly, I would like to discuss the investment of funds that are not taxed. For example, we might get a bunch of money for our birthdays, weddings, or just from loving grandparents. These gifts are rarely declared on taxes. Also, there are some professions that work on a cash basis (i.e. taxi drivers, some truck drivers, some labour jobs etc...). In these sort of situations where the cash is not being taxed, then the TFSA will definitely be a better strategy, since the taxation on the invested money is 0. Please note, I think paying taxes is very important, and I am not suggesting that we all try to hide income from the CRA. I think every citizen should pay their share of taxes (but not a penny more!).
Just as every other strategy, this isn't the be-all, end-all of investing. And as well as all other strategies, please consult your financial advisor and do your own homework. If you have any questions, please do not hesitate to contact me!
