This week’s article is inspired by an excellent question from Notre Dame High School’s Career and Life Management class.
They asked, “Which is better, investing in an RRSP or TFSA or outside of a registered account?”
It depends! First, let us understand a concept that Mr. Money knows all too well: tax-efficient investing.
Tax-efficient investing is the idea that investment income should be taxed at your lowest possible marginal rate, ensuring that your investments are exerting the maximum “monetary effort.”
From my friend (and yours too) Mr. Money’s point of view, this begins by participating in his employer’s pension plan.
Any contributions made to the plan are deductible against employment income.
In addition, his employer matches his contributions to some pre-determined maximum.
For example, a $1,000 contribution could potentially be matched to a maximum of $1,000.
The result is that with little effort Mr. Money’s investment doubled, and we have not even begun to consider investment income and other benefits that employer pensions offer, such as cost-of-living adjusted pension payments.
Maximizing contributions to employer-sponsored pensions is just one way that Mr. Money ensures he’s investing efficiently. He also tries to maximize registered retirement savings plan (RRSP) and tax free savings account (TFSA) contributions. However, in doing so he has to make a choice about which investments he will put into his RRSP and TFSA accounts, and which he will keep outside of these accounts.
Remember, RRSPs and TFSAs are not investments in themselves. They are accounts which are registered with Canada Revenue Agency, ensuring investors get the benefits of using these types of accounts.
Mr. Money’s job is choosing which investments he deposits into these accounts.
Interest income is of course fully taxable, so from Mr. Money’s point of view, depositing interest bearing investments into an RRSP or TFSA ensures no tax impact on interest income.
Think of it this way: by the Rule of 72, an interest-bearing investment that earns six per cent before taxes will double in value in 12 years. Assuming a tax rate of 30 per cent, an after-tax return of 4.2 per cent requires an additional five years to double in value. So an interest-bearing deposit into a TFSA or RRSP ensures that the interest income is accruing to you and not the tax collector.
Mr. Money prefers to invest in dividend-paying stocks and growth stocks outside of his registered plans so that he can claim the tax benefits on these forms of income.
For example, dividend income earned outside of an RRSP or TFSA carries a lower effective tax rate, given that investors can claim the dividend tax credit. Claiming this tax credit means that $1,000 in dividends, paid to an investor with a 30 per cent tax rate, results in a total tax bill of $207, compared to a $300 tax bill if this income was paid out as interest.
Capital gains income, earned outside of an RRSP or TFSA, are taxed at an investor’s marginal tax rate, but what Mr. Money really likes about capital gains is that only 50 per cent of gains are taxed. So only $500 of a $1,000 capital gain would be taxed, leaving the investor with more money to reinvest.
In other words, a pre-tax capital gain of $1,000, on an original $10,000 investment, would be equal to an after-tax yield of 8.5 per cent, assuming a 30 per cent tax rate. If this income was paid as interest income, the total tax bill would be $300, resulting in a seven per cent after-tax return.
In other words, you would need almost two additional years to double your investment by the Rule of 72.
Sound investment choices are not just about which investments to buy but where your investments will “live.” Tax-free and tax-deferred savings vehicles, such as TFSAs and RRSPs, are excellent places to deposit interest-bearing investments, whereas dividend and capital gains income do not necessarily need sheltering from taxation.
As our friend Mr. Money puts it, your investment portfolio is like your home. It needs to be properly insulated to protect against a loss of heat. In a similar way, your investment returns need to be insulated against the impact of taxes.
Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.