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RRSPs and TFSAs should be included in an affluent Canadian’s tax-saving efforts. The problem is these shelters deplete fairly quickly for affluent investors. Let’s look at what role an RRSP and TFSA play in a high-net-worth investor’s portfolio.
RRSPs: A Tax Deferral Tool
Registered Retirement Savings Plans (RRSPs) are Canada Revenue Agency (CRA) registered investment accounts aimed at encouraging Canadians to save for retirement. Amounts contributed towards an RRSP are from an investor’s pre-tax dollar income.
The contributions are deductible so they will reduce the tax bill in the near-term. The amount, though, will become taxable upon withdrawal. So does this mean that affluent investors only end up with marginal savings as their tax bracket at the time of withdrawal may also be higher then the average investor?
TFSAs: Tax Avoidance for Growth Dollars
A Tax-Free Savings Account (TFSA) is an all-purpose savings account. Contributions made towards a TFSA are not tax-deductible since they are funded with after-tax contributions.
The interest and capital gains accrued or realized, however, are tax-free. Investors may withdraw their funds at any time and for any purpose without worrying about tax or penalties.
Let’s dig a little deeper into how to optimize the benefits of RRSPs and TFSAs for affluent investors.
Max-out Utilization of RRSPs
During tax years with a higher marginal rate of tax, investors should still aim for deferring their taxes until retirement when they may be taxed at a lower rate, as peak wealth generation years are typically over.
An investor’s maximum RRSP contribution in a given tax year cannot exceed the lower of:
18% of the previous year’s earned income, or
Maximum per-annum contribution limit prescribed for a given tax year, or
The limit that remains subsequent to contributions from any company-sponsored pension plans.
Affluent investors can contribute up to $27,830 (contribution limit for 2021), in addition to any accumulated room for contribution since 2009 (for each year that the investor was 18 and older).
While these contributions are indexed for inflation each year, it’s unlikely to ever provide a big enough tax shelter for affluent investors to truly matter by itself as a tax mitigation strategy on a strictly annual consideration.
While investing pre-tax dollars to an RRSP is an age-old strategy for trimming the tax bill, most high-net-worth investors will end up withdrawing the money in a higher than average tax bracket, too. The only major benefit that remains, then, is tax-free growth.
The resultant tax-deferred compound growth investments can generate some extraordinary returns for affluent investors.
For example, let’s consider a high-net-worth investor who contemplates investing $20,000 in an RRSP in 2021. The investor will reduce their current year’s tax bill by $8,000 (assuming a tax rate of 40%). Additionally, the returns generated on the invested amount will continue to grow tax-free until withdrawal.
If the investor chooses to invest outside of the RRSP, the investor will have a net investible amount of only $12,000 after paying $8,000 in taxes. Further, all the realized returns will be taxed too.
Let’s look at a chart that compares these two options.
It is evident which option delivers superior returns. Even after factoring in a 40% tax rate at withdrawal, the tax-deferred returns offer almost 100% increase over investments outside of an RRSP.
Underpin Tax-Free Growth with TFSAs
Wealthy investors should also entirely utilize their TFSAs.
The contribution cap for TFSAs is also indexed for inflation and stands at $6,000 for the 2021 tax year. The maximum cap on TFSA contributions is $75,500. TFSAs have a narrow scope for affluent investors, in that they offer tax shelter for the growth of the aforementioned contribution total of $75,500 with similar benefits of compound growth for the returns portion of the investment while in the TFSA.
The bottom-line benefit of RRSPs and TFSAs for affluent investors is their ability to mitigate a portion of taxes, and also provide increased tax-deferred returns. These investments can also reduce an investor portfolio’s standard deviation. Affluent investors will certainly be prudent to fully utilize these investments as the compounding effect can maximize the efficiency of their investment returns.
Every little bit can compound into large gains over a lifetime.