We previously have written extensively on various aspects of the new tax-free savings accounts. In preparation for a presentation at the 2009 Conference of the Canadian Institute of Financial Planners, Don conducted research into some longer term strategic aspects of TFSAs and their role in wealth accumulation. Specifically, they addressed two questions:
- First, how do TFSAs integrate with other savings vehicles (RRSPs and Trading accounts) for different income levels?
- Second, how do TFSAs integrate with other savings vehicles (RRSPs and Trading accounts) for asset allocation investment strategy?
TFSAs, RRSPs and Trading accounts as retirement building vehicles
All of these tests presumed a finite amount of saving dollars that had to be allocated amongst the three savings vehicles.
For low income earners (defined as being in the lowest tax bracket, which is currently approx $40,000 in 2009), the research concluded that they were better off to direct their saving to TFSAs instead of RRSPs. Middle and high income earners both were better off to redirect annually sufficient of their RRSP contribution to make the maximum annual TFSA contribution (presently $5,000). The tax-free aspect of TFSAs exceeded the temporal tax break from RRSP contributions, and in the case of low income earners, the lower taxable income in retirement opened the door to various income assistance (as we know it now) in retirement. In all cases, the advantage of the TFSA compounds all the more with a longer life expectancy.
TFSAs, RRSPs and Trading accounts and tax-smart investing strategy
Our articles on TFSAs include a chart on the comparable tax treatment of different kinds of investment income in the three kinds of savings vehicles. The kinds of investment income include interest, Canadian dividends, foreign dividends, capital gains and trust income. The second part of the research addressed what kinds of investments (and therefore related investment income) should be placed in each type of account…. in technical terms … what asset allocation plan should exist in each vehicle, such that the sum of the parts arrives at the desired overall asset allocation plan. All of these cases assumed a middle income earner.
In the first case, where there were only TFSAs and RRSPs (ie no Trading account), there was significant long term advantage to loading the equity component into the TFSA and the fixed return component into the RRSP.
In the second case, where all three types of accounts were used, again there was significant advantage to loading the equity component into the TFSA; however, this advantage only started to accrue after retirement (assumed age 65) and until death.
In the third case, we tested the ordering of retirement withdrawals between TFSAs and Trading accounts. The highest value at age 90 occurred where retirement withdrawals were taken from the Trading account, not the TFSA, and the Trading account was loaded with the fixed income component. The second highest value used the TFSA as a retirement cash flow source and that account loaded up with fixed income. It appears the old “matching of funds” rule applies! In summary, your investment strategy for your TFSA first must address the question: What and when is the money for? The time horizon dictates the investment strategy and also how tax-smart that strategy can be.