The Power of Tax-Free Growth – Maximizing Registered Plan Benefits

We have spoken about the virtues of using tax-sheltered or tax-deferred plans and the long-term benefits they deliver. We wanted to take a moment and show you how wonderful it can really be. We will focus on the tax advantages, which can be attained in a few ways.

Avoid the tax drag by utilizing registered plans

The first tax advantage is the power of tax-free compounding of investment income generated within a registered plan relative to a taxable non-registered account. In contrast, the taxable non-registered account incurs an annual (or periodic) tax drag since there is no opportunity for a tax deferral of investment income generated. This difference accumulates and compounds over time, making the registered plan a more tax-advantaged option for investment.

Within a non-registered environment, there is a cost to earning investment income in the form of tax. This is particularly true when that investment income is in the form of distributions (irrespective of whether they are reinvested or received in cash) or in the form of realized capital gains. The funds needed to pay the tax must come from somewhere, so the cost is real. Where that same investment income is earned within a registered plan (e.g., an RRSP), taxation of investment income is deferred until some future point when the funds are withdrawn. With a TFSA, proceeds withdrawn are free of tax, though contributions are made after-tax.

Let’s look at an illustration. For simplicity, we have assumed that the individual continues to earn the same amount of income until 65 years of age and that places them consistently at a 35% marginal tax rate (MTR). As not all investment income generated is equal, we will assume that the annual investment income generated within the taxable non-registered account is in the form of capital gains – the most tax-efficient form of investment income at those marginal tax rates.

The table below illustrates the accumulated after-tax difference in the closing balance between an RRSP/TFSA and a taxable non-registered account earning 5% in annual capital gains over 25 years. Annual contributions are $5,000 into the taxable non-registered account and the TFSA. The pre-tax equivalent of $5,000 after-tax is made into the RRSP ($7,692.31)¹. For the taxable non-registered account, we have assumed that the annual tax bill is paid with funds from within the account. In the case of the RRSP, we have assumed contributions are made pre-tax. For the TFSA, no tax is paid when the amounts are withdrawn.

Notice that the RRSP/TFSA balance is the same at all times. This is because we have assumed the same MTR throughout the entire period. As a result, from a registered plan perspective, the RRSP and TFSA remains tax neutral (more on this below). Also, the difference between the after-tax balance of the registered plan versus the non-registered plan compounds over time. In respect to the non-registered plan, total taxes paid over the 25-year period amount to $20,258.83² with the rest of the difference ($9,802.53) being attributed to the lost compound growth as less capital remains invested over the period. Yet, we have not considered the tax arbitrage opportunity with respect to the RRSP/TFSA account when the individual enters the distribution phase. In the distribution phase, money begins to be withdrawn from the registered plan where the individual is either in a higher, lower or identical MTR than at the time of contribution. The difference in MTR will either result in a tax advantage or disadvantage.

RRSPs and TFSAs are tax neutral

It is important to consider the notion that the RRSP and TFSA are designed to be tax neutral. The table below illustrates this, assuming a constant MTR.

That said, there remains an opportunity for tax arbitrage. The tax arbitrage can be quantified as the difference between the individual’s MTR when contributions are made versus the MTR when tax is realized. The table below illustrates this concept. 

Registered plan coordination – a lifelong pursuit

A good long-term financial plan should be tactical and strategic, utilizing the features and benefits the RRSP/RRIF and TFSA offer. The goal is to work towards maximizing the ability to realize absolute tax savings through coordination between the RRSP/RRIF and TFSA throughout one’s life.

As one starts their career, they are generally likelier to be in a low MTR, reflecting entry-level earnings. Contributing to the TFSA would be ideal at this stage based on our earlier discussion.

As one advances in their career, increased earnings bring an increase to their MTR, which would then shift their preferred investment vehicle for new contributions from the TFSA to the RRSP. In fact, this may be a good opportunity to also “re-locate” existing TFSA savings to the RRSP to maximize the tax arbitrage opportunity. Withdrawals from TFSAs are recoverable via an addition to contribution room the following year. Wherever possible, RRSP contributions are prioritized over the TFSA unless contributions to both can be accommodated.

It would be improper not to mention the First-Time Home Savings Account (FHSA), a plan that combines the best of the RRSP and the TFSA into one. Tax planning opportunities are abundant here, with FHSA contributions being tax deductible and not requiring earned income as with RRSP contributions. FHSA contributions can be funded by new money or from existing TFSA funds. FHSA investment income earned within the plan is tax-free and withdrawals of all the investment income and contributions also tax-free for eligible withdrawals used to purchase a home. While the features and benefits of the FHSA are not discussed here, there are eligibility conditions for establishing an FHSA and for withdrawing tax-free. Finally, where the FHSA is not needed or eligible by the plan expiry date, a transfer is permitted into one’s RRSP that is both tax-free and does not require nor use up RRSP contribution room!

A transfer to a RRIF is required when the RRSP expires as of December 31, the year the RRSP annuitant turns 71 years of age. Note that a transfer to the RRIF can occur prior and comes with some advantages with respect to the mandatory minimum payments and income splitting opportunities.

Once in the distribution phase (i.e., “retirement”), a shift may once again be advantageous by redirecting ‘excess’ RRIF withdrawals into the TFSA, including new after-tax income earned, assuming the individual will continue to remain in a low MTR. As a reminder, there is no TFSA expiration, and the plan can be kept active with regular contributions continuing well into retirement for any purpose.

Both RRIF and TFSA withdrawals fund retirement income needs, with the TFSA offering greater overall flexibility. With the addition of the FHSA, together these plans can accommodate life and retirement needs on a tax efficient basis. The main benefit is leveraging the plans to avoid the periodic tax that would otherwise be incurred on the investment income generated within a non-registered plan. As there is no “tax drag” associated with the registered plan, proceeds will generally compound at a greater rate than a taxable non-registered account. Upon withdrawal of the funds from the registered plan, your MTR will determine how well you’ve leveraged the tax arbitrage opportunity.