RRSP, TFSA or pay down debt? Graham Westmacott, CFA Portfolio Manager PWL CAPITAL Inc gwestmacott@pwlcapital.com Waterloo, Ontario April 2013
This report was written by Graham Westmacott, PWL Capital Inc. The ideas, opinions, and recommendations contained in this document are those of the authors and do not necessarily represent the views of PWL Capital Inc. PWL Capital Inc. All rights reserved. No part of this publication may be reproduced without prior written approval of the author and/or PWL Capital. PWL Capital would appreciate receiving a copy of any publication or material that uses this document as a source. Please cite this document as: Graham Westmacott, Portfolio Manager, PWL Capital Inc. RRSP, TFSA or pay down debt? Acknowledgement Thanks to Susan Daley for suggesting changes and helping with the figures. For more information about this or other publications from PWL Capital, contact: 3400 de Maisonneuve Ouest, Bureau 1501, Montréal, Québec H3Z 3B8 Tel 514-875-7566 1-800-343-7566 x264 Fax 514-875-9611 capital@pwlcapital.com This document is published by PWL Capital Inc. for your information only. Information on which this document is based is available on request. Particular investments or trading strategies should be evaluated relative to each individual s objectives, in consultation with the Investment Advisor. Opinions of PWL Capital constitute its judgment as of the date of this publication, are subject to change without notice and are provided in good faith but without responsibility for any errors or omissions contained herein. This document is supplied on the basis and understanding that neither PWL Capital Inc. nor its employees, agents or information suppliers is to be under any responsibility of liability whatsoever in respect thereof.
RRSP, TFSA or pay down debt? A perennial question for investors is the best location for the next dollar they can save: RRSP, TFSA or paying off the mortgage or line of credit. We use a simple model of investment growth to compare each option. First we have to be clear about what we are trying to achieve. Goal: To maximize the after tax return from saving a portion of earned income. It is important to note that this goal is focused on the best use of earned income (pre-tax dollars) deposited to maximize after tax dollars on withdrawal. As we shall see, some confusion arises if the goal shifts to maximizing the return of after-tax income. To get started and to illustrate the model, we start with the Tax Free Savings Account (TFSA). In our diagram below, we show an initial deposit flowing through the TFSA funnel. Over a number of years, n, the investment grows at an annualized rate, r. In reality, the rate of return will vary each year, so r is an average rate. The changing size of the circles as they move through the funnel represents the growth in the original deposit. TFSA Investors get to deposit after-tax dollars into the TFSA. Accordingly, we start with a pre-tax amount, Y and reduce it by the investor s marginal tax rate, t 1, so that the investor deposits Y(1-t 1 ). As the diagram illustrates, after n years the original investment grows to Y(1- t 1 )(1+r) n. Savings within a TFSA can be withdrawn tax free, so the investor receives the full value, Y(1- t 1 )(1+r) n from the initial Y dollars of pre-tax income. We can now use the same model to compare saving within the TFSA with saving within the Registered Retirement Savings Plan (RRSP). The RRSP rules are that an investor deposits after-tax dollars and then receives a refund from the government of the tax that was paid. Thus, for example, if an investor wants to save $1,000 of earned income into his or her RRSP and has a 30% marginal tax rate, then he deposits $1,000 of after tax income and receives a $300 tax credit. The outcome is the same as if the investor contributed $700 of after-tax income and the government contributed $300 1. RRSP, TFSA or pay down debt? 3
Unfortunately, there is ample evidence that investors don t think like this. More often they look at their after tax cash position and ask how much they can afford to save and treat the tax refund as a bonus for consumption. From this perspective, and using the above example, the investor deposits only $700 into their RRSP and consumes the tax credit (of $210) when it appears some months later. How to think of Your RRSP Investment Typical RRSP Thinking We will look at both these scenarios in more detail. The diagram below shows the impact of taking the same pre-tax dollars, Y, as in the TFSA example and investing in an RRSP. RRSP: Depositing Pre-Tax Income 4 RRSP, TFSA or pay down debt?
After n years the investment grows to Y(1+r) n. Unlike the TFSA, the investment is taxed upon withdrawal at the marginal rate applicable, t 2. Thus after tax, the investor receives: Y(1+r) n (1-t 2 ). The difference between investing Y pre-tax dollars in an RRSP compared to a TFSA is: Y(1+r) n (t 1 -t 2 ) By inspection of this formula, we see that if the investor is taxed at a lower rate upon withdrawal than upon deposit then the RRSP gives the better outcome. If you remain resolutely poor or wealthy throughout the investment period, so t 1 =t 2 then there is no difference between the RRSP and TFSA. However, let us revisit the situation of the RRSP investor who looks only at their after tax cash position and decides that they can only afford to deposit the same amount that they deposited into the TFSA and that they will spend the tax refund. RRSP: Spend Tax Refund In this instance, the investor return after n years is: Y(1+r) n (1-t 1 )(1-t 2 ) And the difference between the RRSP and the TFSA is: -Y(1+r) n (1-t 1 )t 2 Note the negative sign at the front of this expression. This means that if you take the same after tax dollars and compare investing them in an RRSP with a TFSA then the TFSA is always the better option (unless you are in the unusual situation of paying no tax in retirement). This is not surprising and merely quantifies the cost of the tax paid by the RRSP investor upon withdrawal. The last option in our RRSP and TFSA comparison considers the same strategy above, but instead of spending the tax credit, investing it in a TFSA. We will call this the RRSP Lite strategy. In this instance we have two funnels: the first for the RRSP deposit and the second for the TFSA investment of the tax credit (in our simple model we consider these are both made at the same time). We will skip the diagrams and go directly to the results. The total investment after n years is Y(1+r) n (1-t 1 )(1-t 2 ) from the RRSP and Y(1+r) n (1-t 1 )t 1 from the TFSA. Computing the difference between the RRSP Lite strategy and the TFSA: Y(1+r) n (1-t 1 )(t1-t 2 ) Thus the RRSP Lite strategy gives a higher return than the TFSA only strategy, provided that the tax on deposit is higher than the tax on withdrawal, but this is a poorer strategy than investing pre-tax dollars into the RRSP. RRSP, TFSA or pay down debt? 5
Debt Payments Reducing debt (mortgage, line of credit) improves net worth (defined as assets less liabilities) as surely as increasing savings. Regular repayment of principal and interest with after tax funds has the same impact on net worth as investing in a TFSA. The investment rate of return is replaced by the interest rate, d, on the debt. Thus if d is greater than the expected return, r, from a TFSA then paying off the debt increases net worth more quickly than investing in a TFSA. The converse is also true. The situation where the cost of debt is greater than the return from an RRSP is more complicated. If the investor s tax rate is unchanged over the investment period then it is better to repay debt if the cost of debt exceeds the expected return from the RRSP. If an investor s tax rate upon withdrawal is less than when the deposit was made, then it is possible that even if the cost of debt is higher than the expected return from the RRSP, then the RRSP is the better choice 2. These comments assume that the debt and the investments are held over the same period. Conclusions Assuming an investor s tax rates fall in retirement then RRSPs are a better use of a dollar of earned income (pre-tax dollars) than the TFSA. The best use of the after-tax dollar is the TFSA. Paying down debt, if the cost of debt is greater than the expected return from a TFSA, is the best use of an after-tax dollar. Paying down debt, if the cost of debt is greater than the expected return from an RRSP, is usually, but not always, best use of an after-tax dollar. In our simple model we have made no allowance for the shifting landscape of benefits and credits due in retirement, especially for lower income Canadians. As observed by other authors 3, the effective tax rate for lower income Canadians, due to the loss of benefits and credits may actually be higher in retirement. Footnotes 1. A Government deposit directly to RRSP accounts in lieu of a tax refund would seem to be a cost free way of boosting savings rates for Canadians and be comparable to the RESP education grants already in place. 2. For the RRSP to be the better choice, to a good approximation, the expression (t 1 -t 2 )+(r-d)n+(t 1 d-t 2 r)n has to be positive. If the tax rate is unchanged (t 1 =t 2 ) then the advantage of the RRSP is (1-t 1 )(r-d)n. 3. See, for example, http://www.jamiegolombek.com/media/blinded_by_the_refund_2011.pdf 6 RRSP, TFSA or pay down debt?
Graham Westmacott, CFA Portfolio Manager PWL Capital Inc gwestmacott@pwlcapital.com www.pwlcapital.com/westmacott Portfolio Management and brokerage services are offered by PWL Capital Inc., which is regulated by Investment Industry Regulatory Organization of Canada (IIROC), and is a member of the Canadian Investor Protection Fund (CIPF). Financial planning and insurance products are offered by PWL Advisors Inc., and is regulated in Ontario by Financial Services Commission of Ontario (FSCO) and in Quebec by the Autorité des marchés financiers (AMF). PWL Advisors Inc. is not a member of CIPF. For more information, please visit www.pwlcapital.com/westmacott T 519 880.0888 1 877 517.0888
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