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Good post. Thanks. My 2cents:

Somewhat OT, but for most people with a mortgage, I suppose paying down our mortgage as fast as possible is also a good choice.

RRSP's can be also be used to finance post secondary education for you or your spouse (I think the program acronym is LLP). We did that for my wife's master's degree and it was well worth it.

Agree that TFSA is great for the rainy day fund. It's a major improvement in quality of life to a have the equivalent of at least a few months expenses tucked away.

Patrick: "I suppose paying down our mortgage as fast as possible is also a good choice."

You're right, it's often a good choice. I was thinking of leaving that to another post. Basically when comparing a TFSA and a mortgage, it's simply a matter of looking at the interest rate, and adjusting for your own personal risk tolerance.

"RRSP's can be also be used to finance post secondary education for you or your spouse" - true.

I think suggesting it's not complicated is disingenuous. Your scenarios are quite simplified. Consider the first one, the straightforward "40% in, 40% out."

First, we have to construct an easy math universe that has a 40% rate. Let's say 40% is the top, and it kicks in at \$100k. then 20% for \$50-\$99,999, and 10% for \$0-\$49,999. You're making \$110k and have \$10k you're interested in saving.

The TFSA proceeds exactly as seen in your table. The RRSP doesn't. RRSP withdrawals should be considered at their average rate, not the marginal rate.

At the withdrawal end, in order to get to a 40% rate, you need to pass through several lower rates first. We're still going to shoot for \$110,000 in income, since we still want to hit the 40% marginal rate. Since you're a high income individual, the only income outside your RRSP/RRIF is from CPP, \$11,840. Again to keep the math easy, we're going assume that the CPP eats up all the basic tax credits, so both our TFSAer and RRSPer get them. Turns out that to top up to \$110,000, our RRSPer pays \$17,815.70 in tax and has \$6,290 and 8,788 clawed back for OAS and GIS, for an effective tax rate of only 33.51%.

So that \$10k we started with? Now it's worth \$12,008.

Of course, make the tax rates and bracket cutoffs more in line with the real world, and the result changes. Add a small employer pension from that one job you had for 5 years, and it changes some more. I also suspect that TFSA rules will be altered in the future, particularly I'd be shocked if I reach retirement (some 36 years from now) without investment income inside a TFSA being counted towards means-tested benefits like GIS. It would be pretty absurd if I can collect GIS while having a half million or more stashed in a TFSA.

Here's a dumb question.

My wife and I are going from being grad students this year to both being employed next year. We're in our early thirties. No debt, no kids. But no assets, no savings, and no retirement funds. We'll have household income in the range of \$175k and we'll both have decent pensions.

Neither of us have the slightest clue when it comes to managing our money. We would love to get a financial planner who thinks like an economist -- things like this post on savings, and Nick's posts on housing, for instance. But of course, the financial planning industry is filled with commissioned salespeople and charlatans, and the standard designations are unhelpful in finding the right advisor.

Interesting post. I have heard/watched a few pundits in the business give the nod to the TFSA before the RSP. If possible, of course, try to maximize both.

Neil - "I think suggesting it's not complicated is disingenuous"

It is true that working out current marginal tax rates can be quite complicated. E.g. in certain income ranges for people with three or more children, reductions of national child benefit supplement can add 33.3% to current marginal tax rates.

It's also probable that Canada's tax treatment of the over 65s will change in the future. There's been some sudden RRSP rule changes recently e.g. that have caught some people off-guard. Or, to take another example, a couple who maximized the lower-income spouse's RRSP in order to minimize their tax liabilities in retirement turns out to have been wasting their time, as over 65s can now income split.

But the basic principle: RRSPs are best when tax rates are expected to go down, TFSAs are best when tax rates are expected to go up, is sound.

westslope: "If possible, of course, try to maximize both." - Not true. If a person's current tax rate is low enough and future tax rate is high enough, plus the returns on investment are low, unsheltered investing may be better than an RRSP.

I like to interpret RRSPs in the sense that the government becomes a co-investor with you, in a tax deferred fund.

The government’s co-investment is the amount of your tax liability that has been deferred.

When the fund is cashed out, the government’s co-investment will have earned a return that, in effect, pays the tax on your own investment return, while repaying the principal amount of the original tax that was deferred.

So your own investment earns the equivalent of a tax free return because the government co-invested with you. That’s why the RRSP is equivalent to a TFSA, when entry and exit marginal tax rates are the same.

Example:

Suppose you have one-time contribution of \$ 10,000.

Assume marginal tax rate of 40 per cent.

Your refund of \$ 4,000 effectively means that the government has co-invested that tax amount of \$ 4,000 in the RRSP, along with your own \$ 6,000.

Assume a bullet investment for 10 years, where your money doubles to \$ 20,000.

Then you cash in.

Assume the marginal tax rate is unchanged.

You’ll pay \$ 8,000 tax.

The \$ 12,000 return means you doubled your original money of \$ 6,000.

That’s an after tax doubling of money, equivalent to the same return on an original after-tax principal contribution of \$ 6,000 to a TFSA.

Interestingly, the government has also doubled its original money (in absolute terms), which in effect was the investment of your original deferred tax amount, and which itself earned the same tax free rate of return in the hands of the government as did your share.

What some people don’t realize as well is that when you get your refund, that’s actually the repayment of a loan you’ve effectively made to the government. The government should have been in the plan with you from day one, as a co-investor, with you making a \$ 6,000 contribution and the government co-investing with \$ 4,000.

JKH - that insight is especially important for people who are in a position to max out both their TFSAs and RRSPs, and have to decide how to allocate funds between the two types of accounts. Since the government is a co-investor in the RRSP, but you're the sole owner of your TFSA, I think (but need to check the math) that it's usually a good idea to put any investments that might get a very high return in the TFSA.

"What some people don’t realize as well is that when you get your refund, that’s actually the repayment of a loan you’ve effectively made to the government. "

If you make regular, automatic contributions to your RRSP, you can fill out a T1213 and you don't have to lend Jimmy your money for free. But be careful that your employer doesn't screw-up the adjustments though. I work for a large firm, and the incompetent morons in payroll messed-up, reduced my payroll deductions too much, I didn't catch it (I check my online paystub now!), and found myself owing CRA a *ton* (well, for me) of money at the end of the year. Nothing like a little surprise liquidity constraint to ruin your day.

Frances,

Technically, I think it shouldn't make a different whether you put a high return investment into a TFSA or a RRSP, as long as you're thinking in pre-tax dollars. I.e., with an RRSP, if I have \$10,000 of pre-tax dollars to invest, I can invest it all, whereas with a TFSA, I can only invest, say, \$6,000 (assuming a 40% tax rate). It's true, the government shares in the upside on the RRSP, but that's because I'm investing \$4,000 of "its" money that I can't invest in a TFSA.

That being said, I know of at least one strategy that people used where your instinct worked. At one time the CRA took the position that underwater stock options (typically employee stock options) had no value (I'm not a finance whiz, but that's almost certainly wrong. The CRA can be such simple folk at times). So if you contribute a few thousand underwater stock options to your RRSP you wouldn't get an upfront deduction, but the government would collect, say, 40% of the upside. Needless to say, clever investors figured out that if you follow the same logic with TFSAs you can (a) dump a ton of underwater stock options into the TFSA, notwithstanding the relatively low \$5000 contribution limit (in 2009), and (b) you get to keep all of the upside. People who pursued this strategy in, say, the winter of 2009 (when people had lots of underwater stock options) make a fair bit of (tax-free) money when the market rebounded later that year (which is why there are some people running around with six figure TFSAs). Largely as a result, I understand that the CRA is rethinking its position on valuing stock options.

There's another complexity for people to think about. If they're going to be investing in US dividend paying securities, RRSPs are exempt from US withholding tax under the Canada/US tax treaty, whereas TFSAs are not (although who knows, that may be changed when Canada and the US revisit the tax treaty in a few years).

Doh, read your post more carefully, yes, if you're maxing out both accounts, put the high return in the TFSA.

Neil,

Why are we looking at average tax rates on RRSP withdrawals? Given your non-RRSP income when you retire, any additional money coming out of your RRSP will incur tax at your top marginal rate. In fact, in the example you give, the TFSA would beat an RRSP hand's down. Not only would a \$10,000 withdrawal from your RRSP be taxed at a marginal rate of 40% (which is roughly what you pay in Ontario on income over 80-odd thousand dollars), but it would also trigger OAS clawbacks on the amount of the withdrawal. The effective marginal tax rate on RRSPs incomes in that case wouldn't be 33%, it would be closer to 55% (i.e., the 40% marginal tax rate on the RRSP withdrawal, and a 15% OAS clawback.

Let me rephrase that "given your non-RRSP income when you retire, any additional money coming ou of your RRSP will incur tax at your marginal rate". In your example, if you have \$100K in non-RRSP income, taking out your original \$10k RRSP investment will be taxed at the 40% rate (plus the 15% OAS clawback). In that case, you would have been further ahead to invest your \$6k in a TFSA.

but it would also trigger OAS clawbacks on the amount of the withdrawal.

Bob nails an important point. All private pension schemes are money losing propositions. By avoiding them all you can have an income of \$0 upon retirement thus making you eligible for the maximum amount of retirement income from the government despite having considerable assets.

Robert: "All private pension schemes are money losing propositions. By avoiding them all you can have an income of \$0 upon retirement thus making you eligible for the maximum amount of retirement income"

Perhaps I'm missing some sarcasm or irony here, if so, my apologies.

Bear in mind that OAS+CPP+GIS is, at maximum, about \$20,000 per person. That isn't going to finance a lot of holidays in Australia. I'm certainly not going to avoid private pensions in order to get \$6,000 in OAS annually.

TFSAs and RRSPs essentially convert our income tax system into a consumption or expenditure tax. People are taxed on their labour income, but investment income is tax free. Lots of people figure that this is a good idea, because it encourages savings and investment, contributing to economic/productivity growth, etc etc.

Hmm ... all told, if you're 65 and have no savings, what is your government pension when you add up OAS, GIS, and CPP?

Oops. I should have noted that you don't just blow the money you would have invested in a pension on junk, but need to invest it in a non or low taxed appreciating asset. Simply put, you're much better off putting your \$10k per year into a second house instead of an RRSP.

Google to the rescue! Apparently it is about ~24K is you really have no savings. So lets see...

The BoC promises 2% inflation, and they adjust these things for inflation, and say you retire at 65, and you're a little lucky and live to be 85. So that's a geometric series... (Google to the rescue again) the sum (NPV) is 24000((1-(1.02)^25)/(1-(1.02)) = \$768727.

Oh my.

Robert "Simply put, you're much better off putting your \$10k per year into a second house instead of an RRSP."

It depends but, yes, in those two situations I described where an RRSP is a bad investment, a cottage or parcel of land might well be a very good investment. Some friends of mine have just built a beautiful retirement home on the little parcel of waterfront-view land they bought just as they were finishing grad school. Fantastic investment.

A cottage offers income opportunities through renting it out, and also a relatively low cost holiday destination.

The benefits of investing in real estate depends to a great extent on one's ability to contribute sweat equity - buying a home, fixing it up, and then selling it is a tried-and-tested way for people without big bucks of ready cash to generate wealth.

I'm a bit of the Garth Turner school of thought on real estate - I'm not convinced that going forward it's going to offer the same kind of returns that it has now. But remember that I have no training as a financial analyst at all, and my opinions on the future of the real estate market are worth nothing.

confused: My standard recommendation is to start by reading Andrew Tobias's The Only Investment Guide You'll Ever Need. I read it back in high school, and it's been invaluable. For Canadian content, Gordon Pape's books are good.

My view of RRSPs and TFSAs is that as a general rule, TFSAs are better. They share the most important advantage of RRSPs, which is that your money compounds tax-free. They're easier to understand, which is a big plus when it comes to investing. And you don't need to predict what your future marginal tax rate is going to be.

In specific circumstances (you know that your future marginal tax rate is going to be lower than your current marginal tax rate, and you know that you're not going to need the money between now and retirement), RRSPs may be better. But in general, I'd invest in TFSAs first.

Russill,

I'm agnostic between the two, but I'm not sure that TFSA's are inherently better than an RRSP. They're not really easier to understand, in fact a lot of people have been burned as a result of making over contributions (though chalk that up to the incompetence of Finance and TFSA providers/advisors). Moreover, because it's harder for people to withdraw money from RRSPs (and generally triggers a tax hit), they're probably a better vehicle for long-term savings (though balance that against the liduidity of a TFSA). And you sort of have to predict what your future tax rate will be with a TFSA. If it could be lower than your current rate, RRSPs may be a better vehicle (in that respect the uncertainty for TFSA and RRSP are the same).

Confused: Try Chilton's books or Gail vaz Oxlade's books/blog (she just entertaining in her own right). I agree with you about financial planners/adviors - think about it, if they had any special insight into making investments, they'd be running a hedge fund making millions, not helping little old you for a 1% "service fee" from fund companies. I think the Chiltons, Oxlades, Papes of the world suggest that, if you're going to use an advisor, get a fee-based advisor you know that they're working for you.

Russil "as a general rule, TFSAs are better"

Another argument in favour of TFSAs is this:

Suppose you really aren't sure which one is best for you, and the best option isn't obvious from the simple guidelines given above (e.g. your household income is between \$40,000 and \$80,000 and you've got a couple of kids). Then put the money into a TFSA. You can always move the money over from a TFSA into an RRSP next year - tax rates aren't going down any time soon.

But once the funds are in a RRSP, it's costly to transfer them into a TFSA - it triggers tax liabilities, and the contribution room is lost forever. So, when in doubt, TFSAs.

A few points have not been discussed.

With a TFSA you are allowed to short sales. This is important to me.

Most people underestimate the probability that one spouse die. In that case, all RRSPs are grouped together with a marginal tax rate increase and a possible OAS clawback.

@Bob: "Why are we looking at average tax rates on RRSP withdrawals?"

First, you should look at the average rate on the RRSP income only, which is what I did. I also factored in the OAS/GIS clawback. Obviously if you have \$80k in non-RRSP income (well, \$100k in my example), then yes, your whole withdrawal will be taxed at your top marginal rate. But what is that income, where does it come from?

My point was that the decision between RRSP and TFSA is indeed complex and situation dependent. If your private savings are your only retirement income source, you get a different result from someone with pension income or a part time job.

But my example was based on a savings program where you'd ONLY have CPP, and either TFSA or RRSP income.

"it would be closer to 55% (i.e., the 40% marginal tax rate on the RRSP withdrawal, and a 15% OAS clawback."
If you have enough non-RRSP income for the entire withdrawal to be at the top marginal rate, then your OAS has already been fully clawed back. You can't have it both ways.

Patrick beat me to the T1213 point I was going to make.

There are online calculators where you can enter your tax situation and it will tell you if TFAS's or RRSP's are better. Taxtips.ca is a good one. They also have a great online calculator so you can estimate your total tax liabilities. I find this of great value when looking at a job; I convert the pre-tax headline pay into after-tax pay so I can do a budget and therefore estimate how much apartment I can afford.

confused:

I repeated what Bob Smith said. Most financial advisors have little or no actual experience in investing. They collect fees. You cannot reasonably expect a "financial advisor" (read salesman) in Anywhere, Canada to have market-beating advice and a track record to prove it.

I have sat in product sales meetings. Eyes glaze over when talking about the how the product works, everyone perks right up when fees and trailers are discussed.

The calculators at taxtips.ca are good start on assessing your situation. They work on both you and your spouse's income and allow for spousal RRSP's and other commons transfers. Best place to start.

If you are considering an RRSP investment, use the Saskatchewan Pension Plan as a benchmark. It is available to any Canadian citizen, counts as an RRSP contribution and runs only two funds, a balanced fund for long-term investments and a pure money fund for short-term transitions. Investments are locked in like a pension, you can't withdraw it. The MER is 1% which is the best-in-class in Canada. There are no salesmen either. Cross-selling is a mainstay of the financial industry so you can spare yourself the annoyance.

Do consider your insurance situation too, disability especially. This is the most complicated form of insurance contract in the Canadian market so I strongly recommend that you take an evening to become educated.

I will bet my hat that you will receive one of two forms of DI through an academic group employer: Grouped Accident & Sickness (a string of individual policies) or a Wage-Loss Replacement Plan (one master policy). GA&S plans are paid for with after-tax dollars and the benefits are tax-free; Wage Loss Replacement Plans are tax-deducible and have taxable benefits.

The standard for Canadian DI policies is 2 years Regular Occupation and then Any Occupation to 65. Regular Occ disability means you are disabled from your last occupation, Any Occ mean any occupation you are suited for by reason of education, training or experience. This puts the insurance company in the driver's seat, get away from this if you can. You can get an individual policy to upgrade to Regular Occ. to 65 to wrap around your group plan. It's easy and standard. Also look at Partial/Residual disability, which is less than 100% disability. If you are disabled, you will thank your lucky stars if you have these features, they address the main problems people have with DI policies and bring them up to what they mentally expect.

DI is the least understood and most complicated financial product in the Canadian retail market.

westslope: "If possible, of course, try to maximize both." - Not true. If a person's current tax rate is low enough and future tax rate is high enough, plus the returns on investment are low, unsheltered investing may be better than an RRSP. -fw

Fine--if all those conditions are met. Investor competence is an implicit assumption often made in these discussions that does not by any means reflect reality.

I suppose if you are advising dope dealers, tobacco smugglers, gun runners, prostitutes and others who live off mostly untaxed income, the TFSA and unsheltered accounts would be the way to go too. Don't laugh. Take our economist-trained prime minister Stephen Harper. Mr. Harper LOVES black markets. Fearful Canadians--his constituency--LOVE black markets.

In fact, I heard a rumour that top Hells Angels capos are funnelling all kinds of contributions to the Conservative Party. It is always nice to know that the prime minister is rooting for your bottom line when income is sourced from marijuana, cocaine, guns and girls. MCGG for those looking for an acronym.

westslope: ?

Determinant's stuck in spam again (I can't rescue you, since it's not my post).

"But my example was based on a savings program where you'd ONLY have CPP, and either TFSA or RRSP income."

Even in that example, you should only look at the marginal tax rate, because you're making a marginal decision to invest in TFSAs and RRSPs. You can invest an extra \$10k in RRSPs, and have an income (in your example) of \$110k when you retire, or invest \$6k in TFSAs, and have a taxable income of \$100k when you retire and \$6k in tax-free money. What matters in that example isn't the average tax rate, it's the marginal tax rate. The only time the average tax rate matters is if your choice is to either save everything in a TFSA or everything in a RRSP and you'll have no other income.

Weslope - if you're advising drug dealers, gun runners, and they aren't reporting their income, TFSAs are the ONLY way to go, because they won't have any RRSP room (also, advise them to pay their taxes before they caught - a particularly nasty outcome for drug dealers is that they get arrested and the government seizes their money as proceeds of crime, then the CRA comes along and points out that they owe some money on all those proceeds)

Neil - "If you have enough non-RRSP income for the entire withdrawal to be at the top marginal rate, then your OAS has already been fully clawed back. You can't have it both ways."

The OAS doesn't get fully clawed back until just under \$110k. So in your example, you still have to worry about OAS clawback.

"So, when in doubt, TFSAs."

You can also use TFSAs as collateral for a loan, which you can't do with RRSPs, so another point in their favour.

Determinant: "If you are considering an RRSP investment, use the Saskatchewan Pension Plan as a benchmark."

You know, I've though about investing with the SPP. I'm wedded to index funds with low MERs (ETFs and the TD e-series funds), but the SPP has a good product, so each year I wonder about tossing a portion of my savings in with them. Maybe this year.

Frances,

"Since the government is a co-investor in the RRSP, but you're the sole owner of your TFSA, I think (but need to check the math) that it's usually a good idea to put any investments that might get a very high return in the TFSA."

I'm not seeing that.

In my example, you invest \$ 6,000 of after-tax money in either case, and the after-tax returns are equal, regardless of the size of the assumed pre-tax return.

JKH: Yep. If T1=T2, then TSFA=(1-T1)X(1+r)^t = X[(1+r)^t](1-T2)=RRSP

Bob:

If you feel you have the ability to successfully invest in ETF's, go for it.

I like the SPP because there is no management decision involved, they won't switch your funds and they don't have a herd of mutual funds to do that. What you see is what you get, it's very rare to get that level of transparency in an investment.

It's a good way to evaluate if your own efforts can increase your investment returns.

I hope that if a few things work out I will use the SPP as the top-up for my retirement planning. I am competing for a position with a very nice pension.

BTW, why does the spam filter hate me so much?

Determinant - try doing several shorter comments instead of one long one, shorter comments seem to be more likely to get through the filter.

JKH, Nick, frame the problem this way instead.

You have \$10,000 in RRSP room and \$10,000 in TFSA room. You have enough funds to max out both.

You want to invest \$10,0000 in opportunity A, which you anticipate will give you a 3% rate of return. You want to invest \$10,000 in opportunity B, which you anticipate will give you a 6% rate of return. (Let's just assume that is some limit to the amount that can be placed in opportunity B without triggering a CRA investigation).

If we assume away all issues related to risk, it's clearly better to put the opportunity B funds in the TFSA and the opportunity A funds in the RRSP.

Frances,
Yes and no.
If a higher rate of return means a higher income tax rate...yes.
If a higher rate of return do not means a higher income tax rate...no.

Am I missing something?

Normand - in both of these examples, \$10,000 is put into an RRSP - this is an investor who's maxing out both (so presumably someone who's reasonably high income). In this case, it's better to have the low return asset in the RRSP, because those returns are going to be taxed, and the high return asset in the TFSA, because those returns are not going to be taxed.

There's an annual tax conference I go to most years that's a combination of economists and accountants - as soon as TFSAs were announced the accountants were working out how to create investment vehicles that could be used to generate very high returns within a TFSA. And as an economist I'd thought they were all about providing investment opportunities for low income Canadians...

Frances: OK. Got it.

Frances,

“You have \$10,000 in RRSP room and \$10,000 in TFSA room. You have enough funds to max out both. You want to invest \$10,000 in opportunity A, which you anticipate will give you a 3% rate of return. You want to invest \$10,000 in opportunity B, which you anticipate will give you a 6% rate of return. (Let's just assume that is some limit to the amount that can be placed in opportunity B without triggering a CRA investigation). If we assume away all issues related to risk, it's clearly better to put the opportunity B funds in the TFSA and the opportunity A funds in the RRSP.”

You’re putting \$ 10,000 of after-tax money into the TFSA, but only \$ 6,000 of after-tax money into the RRSP. So the reason for putting the higher yielding return funds into the TFSA is not because it’s a better tax shelter, but because you’re putting in more after-tax money. Maybe that was your premise - but it works because its apples and oranges in terms of a \$ 4,000 difference in after-tax room contribution room.

JKH - like a lot of these investment things, it's pretty obvious once you think about it, isn't it? But until I read your last comment, it hadn't occurred to me that \$1 of TFSA room is worth that much more than \$1 of RRSP room, I'd just mentally being equating the two...

Bob Smith: I'm not advizing anybody but from what I understood successful black marketeers are very careful paying all bills (e.g., hydro) and tax bills.

That is how, for example, ex-marijuana seed exporter Marc Emery stayed out of trouble with Canadian authorities. The fact that he paid Canadian taxes was insufficient to dissuade American drug warriors.

All this solid advice on how to best save black market income also applies to untaxed income from so-called legal activities, too.

You have assumed that someone will make the same kind of investments in an RRSP as in a TFSA.

But what if they don't? What if someone has both an RRSP and TFSA, and wants to make both higher risk (e.g., equities) and lower risk (e.g, mid-term government bonds) investments. How should they do it?

It seems to me that the investment with the highest expected return should be in the TFSA, since you will not pay tax on those extra profits.

But this raises a question: Should TFSA investments generally be more aggressive than RRSP investments, even if you only have one of these vehicles?

In the case when you can maximize both RRSP & TSFA, yes, it is likely that the optimal portfolio in each is different.

First, most people in a position to maximize contributions are already paying the highest marginal rate. Their future rate of taxation to be concerned with is the average, not the marginal; this will be higher only if the tax regime in general rises substantially. So they should discount the risk that their personal tax rate will be higher in future then it is today. In that case, both shelters will be effective if they generate positive return, but ...

The TSFA has considerable liquidity value over the RRSP, because you can withdraw from and restore it as needed and because it can serve as collateral. Therefore it should be invested in something you are willing to liquidate, but that still has enough return to be worth sheltering. In "normal" interest rate regimes, a diversified bond position would be ideal. Admittedly, this usage conflicts with the desire to generate tax-sheltered returns from short positions. But that is a minority of investors.

The RRSP has considerable insurance value, because it pays off the most in states of the world where you most need the money. In other words, it has option value. Like all options, the longer the potential exercise date, the more valuable. You should invest accordingly.

rabbit - I need to do the math on the risk thing but here's the intuition: the government owns part of your RRSP, that means the government takes 25 or 40% of any gains/losses. That basically reduces both the upside and downside risk of an RRSP investment, making it overall less risky. So take an investment that has a 50% chance of generating a 20% return, and a 50% chance of generating nothing. Put that into an RRSP, and it becomes a 50% chance of generating a (1-t)*20% return, and a 50% chance of generating nothing. The variance of your portfolio has just been reduced.

Frances, I believe there's a paper out there that does that math with respect to the taxation of capital gains/losses (different context, similar analysis). For the life of me I can't remember the paper (you may be familiar with it, but if not Michael Smart would know it - I read it for his class).

RRSPs have a significant disadvantage with respect to capital gains: RRSP withdrawals are always taxed as ordinary income.

For simplicity, suppose you have a 50% marginal tax rate. If you realize a \$10,000 capital gain outside your RRSP, you pay \$2,500 in tax (only one half of capital gains are taxable). If you realize a \$10,000 capital gain inside your RRSP, you pay \$5,000 in tax when you withdraw it!

Russil, that's true, but keep in mind, you gotta invest after-tax funds if you invest outside your RRSP. So, at a marginal tax rate of 50%, you can either make a \$10k after-tax investment outside an RRSP or a \$20k pre-tax investment inside an RRSP (i.e., to invest \$10k after-tax, you need \$20k pre-tax). True, if that investment goes up 100% outside the RRSP, you'll have an after-tax gain of \$7.5k (75% of \$10k). On the other hand, if that investment goes up 100% inside the RRSP, you'll have an after-tax gain of \$10k (50% of \$20k). The after-tax rate of return in an RRSP may be lower (or the tax rate may be higher), but the RRSP is a still a better investment.

Essentially an RRSP is a leveraged investment. You're investing the government's money (i.e., the \$10k in taxes that you otherwise would have paid to have \$10k in after-tax money), but you get to keep 50% of their share of the profit. Good deal - you won't find many other silent partners willing to give you that kind of sweet deal. Too many financial planners focus on the tax rates without thinking about the economics of the investment.

Bob Smith - there's a literature out there on the impact of different types of depreciation rules and corporate taxation on risk taking which is very similar.

Russil - you raise a good point. There are similar issues with holding dividend-paying stocks inside an RRSP, i.e. it's not possible to take advantage of dividend tax credits.

Frances:

I see your point. With RRSPs you are investing the government's money as well as your own.

If one is investing in quality equities for the very long term, however, it is reasonable to assume that you will not lose money, and in fact make money at a faster rate than bonds. Not guaranteed but a darn good guess. If we take superior returns as a given then the numbers seem to suggest that the bonds should be in the RRSPs.

But this argument neglects risk, and if you neglect risk you would invest in equities in both portfolios. I need to think on this.

rabbit,

"It seems to me that the investment with the highest expected return should be in the TFSA, since you will not pay tax on those extra profits."

Nope.

There's absolutely no difference in the area of after-tax return, or risk management around that return, provided that entry and exit tax rates are the same.

The only thing to remember is that \$ 10,000 of room and investment in an RRSP is equivalent to \$ 6,000 in a TFSA, assuming a 40 per cent marginal tax for example. You're investing the same after-tax amount of \$ 6,000 in both cases. The economics of compounding and after-tax return are the same otherwise.

The effect of the government co-investment in your RRSP is that it generates the tax that would otherwise be payable on the return from a non-sheltered investment. And that's the same as a tax-free return, which is what a TFSA gives you directly.

JKH: "The only thing to remember is that \$ 10,000 of room and investment in an RRSP is equivalent to \$ 6,000 in a TFSA"

But if - as is often the case - one is faced with \$10,000 of room in an RRSP and \$10,000 of room in a TFSA - two amounts which are, as you point out, not equivalent - then the high returns are better going in the TFSA, precisely because \$10,000 in TFSA room is worth more than \$10,000 in RRSP room.

Frances,

Yes, provided:

a) You have in excess of \$ 6,000 of after-tax money available to invest in a tax sheltered vehicle (assumed here)

b) You are comfortable with the risk of more than \$ 6,000 of high return investments as part of your overall portfolio mix of after-tax, tax sheltered investments (assumed here)

:)

JKH - yup. Which illustrates an important point: all of this fussing about investments is pretty unimportant to the average Canadian, who is unlikely to have any funds for anything except for paying off student loans, saving for the downpayment on a home, paying off a mortgage, and putting their own kids through school until they're 45, 50, or possibly much older.

Frances: indeed for most people, witness the fact that most contribution room goes unused, the only portfolio mix is mortgage and food. I am in the 20%, neither smoke nor drink. I have an 8 year-old car and yet I will catch up on my RRSP this year and begin my TFSA next fall.
JKH: for those who have a pension plan, would consider that as a risk-free asset that would change the composition of a TFSA or RRSP?

Jacques,

Old article on corporate bankruptcy risk to pension plans:

The wrinkle is that for a company that's in good shape, a defined benefit plan provides benefits that are low risk relative to a defined contribution plan

But defined benefit plans are gradually disappearing

FW: "Russil - you raise a good point. There are similar issues with holding dividend-paying stocks inside an RRSP, i.e. it's not possible to take advantage of dividend tax credits."

True, and if you're making less than \$40k-odd, the dividend tax credit drives the effective tax rate on dividend income to zero. (On the other hand, that's the same treatment afforded to dividends in a TFSA, and as others have pointed out, TFSAs and RRSPs are economically identical, except in terms of the timing of when you pay your taxes. I'll have to do the math, but as with capital gains, I still think you're generally further ahead to be earning dividends in an RRSP rather than in a tax-free acount).

On the other hand, with dividend paying stocks, the tax deferral advantage of an RRSP really matters (if your income high enough that you'll pay tax on the dividends). At least with capital gains, there's at least a theoretical possibility that you can just hold your stock for 40-odd year and defer the capital gain (and the tax thereon) until you sell it (so that, in substance, you get the same tax deferral advantage associated with earning income in an RRSP). By their nature, you can't defer the recognition of dividend income outside of an RRSP.

The other big problem with holding dividend stocks outside an RRSP is that the mechanics of the dividend gross-up/tax credit generates "phantom" income that triggers OAS clawback (at least for some) on income that you never really have.

Jacques, I'd probably treat a private sector defined benefits plan as a form of senior secured corporate debt, which is basically what it is. If the plan is well-funded and the company is strong(i.e., your "debt" is secured by valuable assets and the "debtor" is solvent) that's a low-risk asset. If the plan is poorly-funded and the company is weak, hey, it's like holding a junk bond.

In theory, a public sector defined benefit plan (i.e., one actually backed by the government) should be low-risk (or at least as low-risk as any other government debt). On the other hand, governments can re-write laws and unilaterally amend the terms of your pension (just ask our Greek and Italian friends), companies can't, so query if that doesn't add a different element of risk. If you're the beneficiary of an Ontario government pension plan, for example, I'd say that's a riskier asset today than it was 5 years ago.

Sorry that should read: "I still think you're generally further ahead to be earning dividends in an RRSP rather than in a TAXABLE acount"

It depends, Bob. Stocks inside an RRSP and RRIF do not benefit from the Capital Gains Exemption or the Dividend Tax Credit at any time. When sold and distributed out of the RRIF they can't claim these items, they are taxed as regular income because they were never taxed in the first place. It's the T portion of Exempt (on contribution), Exempt (during accumulation of returns inside plan), Taxable (in full, on distribution).

You can't use an RRSP to defer dividend recognition like that, the entire sale price of the security (assuming it is distributed outside the plan) is taxable as regular income, no capital gains, no dividend tax credits.

Jacques Rene: "JKH: for those who have a pension plan, would consider that as a risk-free asset that would change the composition of a TFSA or RRSP?"

It depends upon the plan. Defined contribution v. defined benefit? How are the funds invested?

My understanding is that pension plans are typically required to keep, say, the percentage of the funds held in equities within some certain range.

If that range is not to your taste, you can use the savings from not smoking, drinking and running an 8 year old car to change your overall portfolio balance.

The original post made the point that, if tax rates are the same before and after retirement, then the same amount in a TFSA or a RRSP will give the same withdrawal amount. If this is true then, the tax deduction for capital gains or dividends makes the TFSA more interesting for the average person.

- OAS clawback reduced
- The average person probability of getting some GIS is increased
- More flexibility
- You can short the market
- No increased tax rate if one spouse die.
- All the money is available all the time.

The TFSA does not allow for recognition of capital gains or losses within the plan. The entire sum, like the funds invested in an RRSP, are Tax-Exempt during accumulation and exempt on withdrawal. TEE and EET, they are both E inside the plan and the TFSA is E coming out. If something isn't taxable, there are no capital gains/losses to be recognized for tax purposes.

Frances:

"My understanding is that pension plans are typically required to keep, say, the percentage of the funds held in equities within some certain range."

It depends in the case of DC pension. In Ontario DC pensions can be managed by a professional pension manager, which is in essence a mutual fund. This one fund in the plan does face "prudent investor" rules. But many DC plans, especially for smaller employers, are merely a selection of mutual funds (often sold by a life insurance company) with the selection left up to the contributor. The reason employers offer this sort of plan is ease for them and the fact that they can take advantage of vesting rules to recover employer contributions if the employee leaves, thus reducing their own cost.

The financial advice provided to mutual-fund menu DC plan contributors is usually perfunctory at best.

DC plans can range from well-funded near-DB plans with professional managers and excellent contribution percentages (15% combined) to miserable menus of mutual funds with high fees and very low contributions by the employer (1% employer per 1.5% of employee, maximum of 5% employer total for pay of \$24K per year).

In short DC plans are very variable. Most would probably benefit from conversion to PRPP's, simply due to the requirement for immediate vesting.

"Jacques, I'd probably treat a private sector defined benefits plan as a form of senior secured corporate debt, which is basically what it is."

No, it's junior, unsecured debt. This is not a point of economics but of law; this is why I say the Deferred Wages Theory doesn't hold water. Under the Bankruptcy and Insolvency Act and the Canadian Corporate Restructuring Act, actual wage arrears for the past six months are to be paid immediately, above secured debt and pension/RRSP contributions (but not liabilities) are included in this provision.

For a DB plan the crucial thing is the employer's liability, as sponsor, to make up the actuarial deficit upon winding up of the plan. This liability is ranked as junior, unsecured debt at law and as such pensioners who have a DB plan that is wound up will very likely take a big haircut. Note that only Ontario has a pension-protection fund and that is only available to single-employer plans. Multi-employer plans (most of the big ones, actually) are not protected. The other provinces and the Federal jurisdiction have no pension protection at all.

The NDP has proposed revisions to the BIA but banks and investor groups are loathe to share secured status with pension plans, reducing their share.

The unfunded pension liabilities are junior, unsecured debt is why I say it is impossible to get money from a dead man, aka a bankrupt company. See Nortel.

Also see this site for a good description of the ranking of creditors (never mind the politics): http://www.carp.ca/2010/03/25/wayne-marstons-primer-on-the-prosed-act-bankruptcy-and-insolvency-act-and-other-acts-unfunded-pension-plan-liabilities/

"It depends, Bob. Stocks inside an RRSP and RRIF do not benefit from the Capital Gains Exemption or the Dividend Tax Credit at any time. When sold and distributed out of the RRIF they can't claim these items, they are taxed as regular income because they were never taxed in the first place. It's the T portion of Exempt (on contribution), Exempt (during accumulation of returns inside plan), Taxable (in full, on distribution)."

I don;t disagree with that description, but the favourable treatment of dividends/capital gains received in taxable accounts will often (and, I think, usually) not be enough to offset the advantage of being able to invest untaxed income in the first instance. True, the money coming out of the RRSP is taxed as ordinary income, but you'll also have a lot more of it. What matters isn't the amount of taxes you pay, but the amount of after-tax income you're left with. In the example I gave above, I'd much rather pay a 50% tax on \$20k of income, than a 25% tax on \$10k of dividends/capital gains.

"You can't use an RRSP to defer dividend recognition like that, the entire sale price of the security (assuming it is distributed outside the plan) is taxable as regular income, no capital gains, no dividend tax credits."

Not quite. If I receive a dividend or realize a capital gain in my RRSP tommorow, I don't pay any tax on that income/gain for a good 30 years or more. - in the meantime I can put that money to work earning more income. If I realize a dividend or capital gain in a taxable account, sure, it's taxed at a low rate, but it's taxed now, not in 30 years.

I think we are talking at cross-purposes, though I don't disagree with your analysis. Dividends and Capital Gains connote specific tax treatments that don't apply to RRSP's or TFSA's. I believe it is clearer to talk about returns [on investment] generally rather than specific forms of return. A dividend, a bond interest payment and a capital gain are all just returns on invested capital inside an RRSP since there is no income tax levied immediately nor is there any difference when the returns are taken out of the plan.

Since dividends and capital gains don't get preferential treatment in RRSP's compared to interest payments from bonds, RRSP's are favourites of investors who love fixed-income securities (though you very likely know that Bob, I am simply stating it for the general audience to make a point).

Bob Smith: "Essentially an RRSP is a leveraged investment. You're investing the government's money (i.e., the \$10k in taxes that you otherwise would have paid to have \$10k in after-tax money), but you get to keep 50% of their share of the profit. Good deal - you won't find many other silent partners willing to give you that kind of sweet deal."

Excellent point -- that's a big advantage of RRSPs that I hadn't been thinking about. (Of course, you still need to be able to predict what your future marginal tax rate will be.)

The usual advice I've seen is that if you want to hold both fixed-income and equity investments (say, a 50/50 allocation), don't use a 50/50 allocation inside your RRSP and a 50/50 allocation outside your RRSP. It's better to hold the fixed-income investments inside the RRSP, and the equity investments outside the RRSP.

Now I'm thinking that the RRSP investments should probably be given lower weight in your portfolio allocation, since you'll still need to pay tax on them when they're withdrawn.

"The usual advice I've seen is that if you want to hold both fixed-income and equity investments (say, a 50/50 allocation), don't use a 50/50 allocation inside your RRSP and a 50/50 allocation outside your RRSP. It's better to hold the fixed-income investments inside the RRSP, and the equity investments outside the RRSP."

I think that advice makes sense on the assumption that you've maxed out your RRSP exemption. I.e., all else being equal, if you're holding assets outside of your RRSP, it makes sense to hold the assets that are taxed at the lower rate (i.e., equities). I suspect a lot of financial advisors don't appreciate the significance of that assumption.

In practice, I suspect few people are in that situation (i.e., how many people save enough so that their annual RRSP limit, and now TFSA limit,) binds? Given the surplus RRSP room out there, not many. In that case, if you believe that your tax rate will be roughtly the same or lower when you retire than it is now (and I suspect a lot of people in their prime savings years, say 40+, have some sense of what their future tax rate will be), I think you'll generally be better off investing inside an RRSP than outside it, regardless of the whether your investing in debt or equity.

In terms of allocation, well, see above, I don't think there's any particularly compelling tax reason for making portfolio investments outside of an RRSP or a TFSA (other, perhaps, than the ability to deduct the interest on borrowed funds if the investment is outside the RRSP/TFSA, though personally I'd rather borrow the money interest free from the government in my RRSP) unless you're one of the very small minority of people for whom the RRSP/TFSA (and if you have kids, the RESP) contribution limits bind. That said, people may have non-tax reasons for holding funds outside an RRSP/TFSA/RESP (liquidity, saving to start a business, kids private schools, emergency funds, etc.). Of course, those non-tax reasons may also drive you to a preference to investing in low-risk assets (debt) rather than tax-advantaged ones (equities)

On second thought, I can think of ONE good tax related reason for not holding a given investment in an RRSP (assuming RRSP limits don't bind), namely if it isn't a "qualified investment" for RRSP purposes.

That being said, Finance has aggressively expanded the definition of a "qualified investment" over the years so that, these days, pretty much anything that a retail investor might want to invest in (or would be allowed to invest in) is a qualified investment. And to the extent it isn't, there's no shortage of investment vehicles that are qualified investments that give you exposure to the underlying investment (for a fee, bien sure).

1) The tax rates you should use for evaluating contributions/withdrawals can only really be done by a calculation with and without the contr/draw. The \$\$ difference divided by the \$cont/draw is the marginal rate. http://www.retailinvestor.org/RRSPmodel.html#taxrates

The tax rate for calculating the savings from tax on growth is your own marginal rate FOR THAT PARTICULAR type of income. http://www.retailinvestor.org/Taxburden.xls

2) The math for RRSPs should not be simplified, because then everyone thinks they know everything. The benefits from RRSP come from taxes saved on growth, changes in rates creating bonuses and penalties, the penalty for a delay in claiming the tax credit, and the effect of clawback of benefits that is usually measured within the tax rate calculation.

These are broken down in this spreadsheet that models a single withdrawal http://www.retailinvestor.org/Challenge.xls The total benefits (not broken down) are measured by the difference between the choices in this next spreadsheet that models withdrawals at the minimum. http://www.retailinvestor.org/OutorIn.xls

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