Comparing the Tax Efficiency of Non-Registered, RRSP, and TFSA Accounts
Let’s imagine that you are 35 years old and you have just inherited $50,000. You wonder whether it makes sense to contribute to your RRSP, your TFSA, or whether you should open a non-registered account and invest the money there.
You live in Ontario and your marginal tax rate at your income level is 29.65%. You know that it’s only the after-tax money that matters but you wonder which will be more efficient for you by the time you get to retirement.
At retirement, you assume that your marginal tax rate is 24.15%.
You decide to use VBAL, the Vanguard Balanced ETF Portfolio, which targets a 60% equity / 40% fixed income allocation. The long-term nominal return assumption after the MER is deducted is 4.84%. In real terms, after an assumed 2.1% inflation, the return is 2.68%.
To simplify this comparison, you work through a comparison on the assumption that you will make this deposit one time, Furthermore, regardless of the account type, you will reinvest all distributions. In addition, no commissions are involved, and you are able to invest the entire $50,000 down to the penny. Finally, you assume that the RRSP contribution generates an immediate tax refund of $14,825 ($50,000 x 29.65%) so that you can begin your investing journey in the RRSP with $64,825.
A note about the Vanguard Asset Allocation ETFs. These are global ETFs, so they have equity and fixed-income investments from Canada, the United States, and the rest of the world. As a result, tax will be withheld at source by the tax agencies of the foreign governments where the various investments are domiciled. That is why there is tax applied on a part of the distributions in the RRSP and TFSA. The non-registered account is fully taxable. However, the characteristics of the various distributions are retained as they are paid out. Fixed income is charged the full 29.65% marginal tax rate, but eligible Canadian dividends are effectively charged 6.39%. Only 50% of capital gains income is taxable. Finally, in the non-registered account, you are eligible to claim a foreign tax credit for the tax withheld on your foreign dividends.
Results After 30 Years
After 30 years of growth and reinvested distributions, you project the following figures:
The RRSP has the advantage over the TFSA because of the tax refund that was invested along with the original $50,000 inheritance. The non-registered account has the frictional costs of being taxed annually on the distributions, so it has fallen behind the TFSA.
Saving Turns to Spending
After saving that inheritance for 30 years, it is time to turn it into income. You are now 65. This is the year that you decide you will convert your RRSP into a RRIF, at least for this comparison. Next year, when you turn 66, you will take the first distribution from your RRIF. Since you were 65 at the beginning of that year, you need to take out 4% of the year-end balance. That works out to a minimum of $5,666 ($141,658 x 4%) before tax. You are now in a 24.15% marginal tax rate in retirement, which works out to an after-tax amount of $4,298 for your first Annual Minimum Payment.
Recognizing that it is the net amount after tax that is what you get to spend, you take out the same amount from your TFSA that comes out after tax from the RRIF, $4,298. Of course, no tax is paid on the withdrawal.
Finally, there is the non-registered account. Again, to properly compare, you take out the same after-tax amount as would be distributed from the RRIF. In the first year, that works out to $5,044 before tax.
You assume that you will live to age 95. You wonder how much if any will be left. Carrying on the projections, you arrive at the following numbers:
The constant friction of taxation results in the complete spend-down of your non-registered account. Perhaps somewhat surprisingly, despite the taxation of the RRIF, it continues to maintain a slightly larger balance than the TFSA. However, you have not yet considered the tax on the RRIF at your death. Assuming there is no surviving spouse or dependent child or grandchild, the RRIF is fully taxable at your marginal rate. In contrast, the TFSA is not taxed, except potentially for a nominal amount based on any growth or income that occurred between the date of your death and the date the TFSA assets are distributed to your beneficiaries.
Theoretically, the full amount of the RRIF can go to the beneficiaries as the tax is owed by the estate, not the beneficiaries. However, if we assume that the assets of the estate ultimately go to the same beneficiaries, the effect is the same.
What Should You Do in Real Life?
These circumstances are not necessarily going to be replicated. It’s not often that people have $50,000 lump sum inheritances to invest, at least it happens less often at age 35. Furthermore, if you are in a lower tax bracket in your income earning years than you will be in retirement, the RRSP may not be the most efficient choice.
While a non-registered account seems to be the least cost-effective, it may be the better choice since you are not obligated to take out money from that account, as you are in the case of a RRIF. Of course, you are not obligated to take money out of a TFSA, either so it should likely have priority over a non-registered account.
There is at least one caveat on the TFSA. The ETF chosen for this example is a middle-of-the-road balanced fund. It is not speculative or high-risk, although it certainly can lose value as it has in 2022. If you have a penchant for more speculative investments, though, you may want to put those assets in a non-registered account so that you can at least claim the allowable capital loss if or when your speculation goes the wrong way and you lose your investment. You cannot claim losses in your TFSA. Nor does the loss work like a withdrawal from a TFSA. You don’t get your contribution room back next year.
In your high-income years, especially if you are taxed at a rate that is likely higher than you will be taxed in retirement, the RRSP is a good choice. If your marginal tax rate is likely to stay the same or even increase in retirement, then the TFSA is probably the preferred choice. And, if you have maxed out both accounts, then investing in a non-registered account is the next logical step.
This is the 165th blog post for Russ Writes, first published on 2022-09-19.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.