The Tax Free Savings
Account (TFSA) that was introduced in 2009, is a great tool for many investors
and can help them avoid paying some taxes with their investment income or gains
that they normally would pay with a non-registered portfolio. However; is the TFSA always the best vehicle
to use?
When investors borrow
money to invest in a non-registered portfolio, in most cases the interest on
those borrowed funds is tax deductible in the year it was paid. That’s not the
case however for a TFSA or other registered portfolios. When money is borrowed to invest in a TFSA,
CRA does not permit you to deduct the interest payments against your income in
the current year, or any other year for that matter. With that, below is an illustration comparing
the two different investment vehicles.
For illustration purposes,
we have to make a few assumptions based on rates of return, interest payments, length
of investment, current marginal tax rate (MTR) and MTR’s in retirement or when
the funds are actually withdrawn from the portfolios, as well as income tax
consequences. Being that $20,000 is the
current maximum (2012) that can be contributed to a TFSA (provided no
contributions were made in previous years), I will illustrate borrowing $20,000
to invest in a TFSA vs. borrowing $20,000 to invest in a non-registered
portfolio and having the funds invested in the same Corporate Class Mutual Fund
or other investment where the gains are tax deferred until withdrawn. I will also assume that the tax refund from
the non-registered portfolio is reinvested so that the comparison is fair.
Assumptions:
·
30 year
investment
·
6% interest only payment
on loan
·
8% return on
investment
·
40% Marginal Tax
Rate today (investors working years)
·
30% Marginal Tax
Rate in retirement
·
Capital Gains tax
treatment on non-registered portfolio
TFSA
$20,000 borrowed and
invested earning 8% compound annually, the total in 30 years would be
$201,253. Minus the $20,000 loan and the
total TFSA value in 30 years is $181,253.
Non
Registered Portfolio
$20,000 borrowed at 6%
interest will create a tax deduction of $1,200 each year against the investor’s
income. At a 40% MTR, this will create a
refund of $480 (1200 x 40%) per year that we would not have with the TFSA and
therefore could reinvest to keep the comparison fair. After 30 years, the portfolio will be
$255,629 if it averages 8% annually. Minus the tax payable of $33,184 {[255,629
– (30 x 480 + 20,000)] /2 x 30%} and also the loan of $20,000, the total
portfolio will be approximately $202,445.
Summary
Using the assumptions that
we have, it clearly shows that using a non-registered portfolio vs. a TFSA is
the better choice when it comes to borrowing money to invest. It is imperative however that you speak with
your financial advisor to ensure which strategy (if either, as borrowing to
invest can be risky) is right for you and to use your own assumptions when
determining MTR’s, interest payments, rates of return and tax consequences.
If you would like more
information on this comparison or have questions, please don’t hesitate to call
me at 778-478-0727 or email at scott.turner@iagto.ca
