I’m typically surprised when I ask my friends if they are utilizing their Tax-Free Savings Account (TFSA). The typical answers range from
“What’s a TFSA” to “Yes…..” followed by silence, to the most common answer, “Yes, but it doesn’t earn very much interest”.
Based on these responses, I know that some people do not really understand what a TFSA is and how is it different from an RRSP.
In simple terms, these are two vehicles in which you can transport your money from today to some arbitrary time in the future. Both give you the option to essentially put whatever you want in them (stocks, bonds, mutual funds) but where they are really different is in their tax implications.
Let’s start with the Registered Retirement Savings Plan (RRSP). Most people understand the concept of a “registered” retirement plan versus a non-registered plan.
The simplest definition is that with an RRSP you are using a tax deferral strategy. You get a tax deduction today and in return, you pay taxes later on the money to pull out of your RRSP.
The crux of the strategy is that when you retire, you should be in a lower tax bracket thus saving money on the tax rate differential.
A non-registered plan means you pay the taxes (ie. no tax deduction) today and you pay the taxes on your gains each year, but when you retire, you won’t be taxed when you pull this money out.
A TFSA is different from both of the above. With a TFSA, you pay the taxes (no tax deduction) today, BUT you are not taxed on your gains, and when you pull out the money, it is also not taxed. It is actually a very good deal on both ends. (Thank you Government of Canada).
Since its inception in 2009, the contribution cap has ranged from $5000 to $10000 and is currently set to $5500 for 2017, for a total of $52,000CAD.
The assumption here is that you know the above and you are trying to figure out based on your income which is the better option, In order to answer this question, we will look at a couple of scenarios and run the numbers to show the implications for both strategies. There are a couple of shorthand calculations that I use personally to help me do some of the number crunching without a calculator which I will demonstrate here.
The rule of 72.
This is a simple yet pretty powerful tool. Basically, if you take 72 and divide it by the annual interest rate, the answer will give you approximately how many years it takes for your principal to double.
If I asked you how long it would take for an investment which yields a 10% return annually to double, the answer is approximately 7.2 years. Using a calculator, 1.1^7.2=1.986. Let’s try one more example. a 5% return should take 14.4 years to double based using this equation. Using a calculator, 1.05^14.4=2.02. The math starts to fall apart as the interest rate goes up beyond 15%, but for the purposes of calculating realistic consistent growth over a long period, this framework works well. The final equation would be written as:
FV=PV(1+i)^(.72/i). PV = Present value. n = interest rate.
FV = Future value = PV*2. .72/i = n = period.
Understanding 2 to the power of N
Another framework that is essential for this type of mental math is 2^n. There is no easy way but just memorizing the equation when N=2,3,4, and 5.
2^1=2
2^2=4
2^3=8
2^4=16
2^5=32
If you combine the power of 2 with the rule of 72, you can quickly calculate how much you will grow given any principal amount, the rate of return and time horizon.
Let’s try an example. If I am 33 today and I invest $5000 today at 9% interest, how much will this $5000 grow by the time I turn 65. Using the rule of 72 to calculate the years to double, 72/9=8. My $5000 doubles every 8 years. with a period of 32 years, the principal can double 32/8=4 times. Using the power of 2, I know 2^4 is 16 so the FV will be 5*16=$80000 when I turn 65. Using a calculator I get 5000*1.09^32=$78816. This works out to an error of 1.5%, not bad for just using our head.
The next important number to understand is what tax bracket are you in today and what are the key tax rate thresholds that you should be aware of. I live in Ontario so my numbers are going to be based on Ontario tax brackets but you can find your income tax rates here. I like using round numbers so here are the ones I would care about in Ontario.
Up to 50K annual income, your combined federal and provincial tax rate is 25%. From 50K to 75K, the tax rate is @30%, 75K to 92K the tax rate is @38%, 92K-142K the tax rate is @43%, and 142K-200K the tax rate is @48%.
The next question is what tax bracket do I expect to be in when I retire. The main advantage of tax deferral strategies is they are based on the premise that you will be in a lower tax bracket when you retire so the taxes you pay in the future should be less than what you are deferring today. I’m a numbers guy so let’s use the example from above and see where an RRSP or a TFSA is a better option for a HENRY.
We saw earlier that a person who had a 32-year investment horizon with a 5K principal at 9% interest ends up with $80K. Now let’s assume the same person makes $100K a year today and will want to pull $50K a year form their savings when they turn 65. For the TFSA example is pretty easy, in 32 years, the person gets $80K tax-free. For the RRSP example, we look at the tax rate for 100K. it is 43% so we will make the assumption that the person will take the tax deduction and buy more of the same asset so the investment amount up front become 1.43*5000=$7150. Since the amount grows at the same rate, it will become 16 times larger in 32 years, so $114,400. We see from above that the tax rate for 50K is 25% so assuming the person pulls from their RRSP at 50K per year, their 114,400 actually becomes 114,400*.75=85,800. In this example, the RRSP is the better option. However, if the person decides that they want to pull out 100K from their RRSP, they would be taxed appropriately at 43% (assuming tax rates stay the same in 30 years), and their 114,400 now becomes $65,208. In this scenario, the TFSA ends up being a better option.
In conclusion, the RRSP and TFSA are both great investment strategies BUT, careful consideration should be given if you happen to be in a higher tax bracket or if you plan on staying in a higher tax bracket once you retire. Please send me any comments or questions as I would love to get your opinion on this topic.
Henry Bill 