MoneySense magazine will be running a story on Canadians who have managed to grow their Tax-Free Savings Account (TFSA) contributions to $30,000, $40,000 or more (if you are interested in sharing your story, see details at the end of this post). The Financial Post also ran a series of stories on TFSA investors during the summer. That got me thinking: how would a passive investor who held Canadian stocks, bonds or REITs in her TFSA have fared assuming she made the maximum contribution on the first trading day of the calendar year. Also, assuming the TFSA investor is an Ontario resident, how much would she have saved in taxes?
In Budget 2011, the Government proposed a clamp down on certain swap transactions between RRSPs and other accounts:
Benefits derived from asset purchase and sale transactions (“swap transactions”) between RRSPs and other accounts controlled by the RRSP annuitant. A swap transaction is a transfer of property (other than a transfer that is a contribution or a withdrawal) between an RRSP and the RRSP annuitant or a non-arm’s length person. Subject to the application of existing anti-avoidance rules, these transfers, when performed on a frequent basis with a view to exploiting small changes in asset value, can potentially be used to shift value to or from an RRSP without paying tax or using RRSP contribution room, as the case may be. An exception will be provided to accommodate transfers from one RRSP of a taxpayer to another RRSP of the taxpayer.
The Budget proposals are aimed at eliminating “advantages” of a swap transaction which are defined as benefits that intend to exploit the tax attributes of a RRSP. However, media reports indicate that some financial institutions are now prohibiting all swaps with RRSP accounts, not just those that run afoul of the new advantage rules.
One hopes that brokers don’t end up issuing a blanket ban on swaps in RRSPs as many did when similar rules were introduced for Tax-Free Savings Accounts (TFSAs). One can skirt a blanket ban on swaps by buying and selling assets separately in two TFSA/RRSP/taxable accounts. But if one or both assets are not liquid (a GIC, for example), a swap may be the only way to exchange assets between a tax-deferred account (an ideal place to hold GICs) and an investment account. At least with TFSAs, one could work around a ban on swaps by withdrawing funds from the account and contributing in-kind during the next financial year. With RRSPs, brokers will be throwing out the baby with the bathwater if they impose a blanket ban on RRSP swaps.
It is undeniable that Tax-Free Savings Accounts (TFSAs) have unique advantages but I’m somewhat surprised by some recent reports that suggest that a lot of Canadians would be better off contributing to a TFSA instead of a RRSP. These arguments forget to take into account the unique advantages offered by RRSPs.
Defer income taxes
RRSPs allow taxpayers to defer their income tax obligations to a future year. Taxpayers with wildly fluctuating incomes can smooth out their income tax obligations by contributing to a RRSP in fat years and withdrawing from it in lean years.
When one spouse earns a much higher income than her partner, she can take advantage of income splitting opportunities offered by RRSP accounts. She can contribute to a spousal RRSP and get her income taxed at the hands of the lower income spouse. She can take advantage of income splitting available to seniors who withdraw from a RRSP or RRIF. The tax benefits of income splitting can be substantial.
Increase in income-tested benefits
It is true that withdrawals from a RRSP or RRIF may result in a reduction of income-tested benefits. But the flip side is often neglected. Contributions to a RRSP reduce one’s taxable income and increases income-tested benefits such as the Canada Child Tax Benefit.
Here’s an example. An Ontario couple with two children, earning $50,000 each will receive an annual CCTB of $335. If the couple contribute $9,000 each to their RRSPs their CCTB payments will increase to $1,055 per year.
Shelter foreign investments from tax
Investors who hold globally diversified portfolios should hold their US equities and US-listed ETFs in their RRSPs. Dividends from foreign equities in taxable accounts are taxed at marginal rates. US stocks and ETFs held in TFSAs are dinged a 15% withholding tax. When held in RRSP accounts, these assets are sheltered from tax until withdrawal.
Canadians in the lowest tax brackets will almost certainly better off saving for retirement inside a TFSA. And those in the highest tax brackets are almost certainly better off contributing to RRSPs at the expense of TFSAs. It is impossible to say with any degree of certainly whether one account is better than the other for Canadians in middle tax brackets because of uncertaintly over future tax rates. The superiority of TFSAs is certainly not the slam dunk it is made out to be in some quarters.