Focus on tax optimization, not tax minimization

by James Parkyn

For many years, Canadians have been conditioned by investment industry marketing to focus on maxing out their RRSP contributions to realize as much income-tax deferral as possible.

While reducing taxes is always enticing, a tax minimization mindset may not be the best approach in the short term, especially for high-net-worth individuals. Instead, you should cultivate a tax optimization mindset.

What is a tax optimization mindset? It’s thinking not just about the current tax year, but how your assets will evolve over the long-term and planning to fund your retirement in a tax efficient way.

We like to discuss this issue with our clients by getting them to imagine three buckets. In the first bucket is assets in registered accounts – RRSPs, Registered Retirement Income Funds (RRIFs) and other similar accounts. When you withdraw money from them, you pay income tax on it.

The second bucket is for non-registered investment accounts and Tax-Free Savings Accounts (TFSAs). Here, income tax has already been paid on the money that went into the account, so you don’t have to pay when you withdraw funds from these accounts. Obviously, if you realize capital gains in these non-registered accounts, 50% of these gains will be taxed at your marginal tax rate.

The third bucket is for business owners who have moved earnings from their operating company into an investment holding company to defer paying personal income tax. Many entrepreneurs accumulate large amounts of money in their holding company and eventually have to pay tax on it, just like on their RRSP savings.

As they head to retirement, people are often focused on the year they will turn 71, knowing they must convert their RRSP into a RRIF by the end of that year. However, they fail to plan for the tax implications of having huge amounts of money in buckets one and three – accounts where they will have to pay income tax on withdrawals.

They work on the assumption they’ll have a large pool of savings to draw on during their retirement but, in reality, they could have only half the amount in after-tax dollars. What’s more, their mandatory RRIF withdrawals might trigger clawbacks on their old age security pension.

That’s why it’s so important to plan early for how you will fund your retirement tax efficiently.

Your plan should include maxing out your TFSA contributions. As I explain in this article, there are no taxes to pay on capital gains, interest or dividends in a TFSA and you withdraw your money from it free of income tax. That makes your TFSA a highly attractive investment vehicle that gives you tremendous flexibility in retirement income planning and in distributing assets to your children upon your passing.

Besides taking full advantage of your TFSA, your retirement income planning may also involve withdrawing money from your RRSP and holding company in the years before you reach age 71 to reduce your tax bill after that age.

While the right mix of assets in different accounts will depend on your individual circumstances, it’s never too early to take a long-term view and start planning.

With the end of the year fast approaching, it’s also time to make sure you’ve made all the moves you need to for your 2022 income taxes. These may include crystallizing capital losses to offset capital gains, making charitable donations and several other possible actions we discuss in detail in the latest episode of our Capital Topics podcast.

While tax planning keeps us busy at this time of year, please remember that optimizing your taxes should be a year-round process and that we’re always here to help.

For more insights into investing and personal finance, please download our Capital Topics podcast.

Why aren’t more Canadians maxing out their TFSAs?

by James Parkyn

We can all agree taxes are a burden we have to bear, but one we can try our best to reduce as much as legally possible.

That’s why Tax-Free Savings Accounts are such a good deal and why it’s so hard to understand why more Canadians don’t take full advantage of them.

TFSAs were introduced by the federal government in 2009 to encourage Canadians to save more money for the future.

While you contribute after-tax dollars to your TFSA, any investment income growth earned inside them is not taxed and withdrawals are not taxable. In other words, there are no taxes to pay on the capital gains, interest or dividends in that account.

There is an annual contribution limit each year, which for 2022 is $6,000. If you don’t contribute to your TFSA in a given a year, your unused contribution room accumulates, meaning you could contribute more than the annual limit the next year. If you were a Canadian resident aged 18 or over when TFSAs were launched in 2009 and have never contributed, you would now have $81,500 in contribution room.

Given how attractive TFSAs are as a savings vehicle, it’s remarkable how many Canadians fail to take full advantage of this opportunity, including many high-income Canadians who presumably could afford to make a $6,000 annual contribution.

The latest statistics from the Canadian Revenue Agency show that in the 2019 tax year 15.3 million Canadians held a TFSA and of these people only 9% had maximized their available contribution room. For the wealthiest Canadians earning $250,000 and over, only about 30% of TFSA holders had maximized their contributions.

The average TFSA fair market value per individual was around $23,000 and the unused contribution room was nearly $38,000. For those earning $250,000 a year and over, the average fair market value was roughly $50,000 and the unused TFSA room was close to $22,000.

The lost opportunity cost represented by these numbers is huge. To illustrate this, consider an investor who contributed $81,500 to a TFSA in 2022, plus $6,000 every year thereafter at a 5% rate of return annually over 25 years. This person would end up with over $556,000 that he or she could withdraw and use completely tax free.

The gains could be multiplied if this investor also contributed to their spouse’s TFSA. You can gift money to your spouse so they can contribute to their TFSA without tax or penalty.

It’s important to note that the above illustration assumes that contributions and investment gains stay in the TFSA for the long term. But many people don’t use a TFSA this way. Instead, they use it like a savings account, drawing money out for short-term expenses such as vacations, vehicle purchases or an emergency fund.

We can see this in CRA withdrawal statistics. They show that TFSA holders had made 5.4 withdrawals on average for an average amount of $8,117.

However, as we saw in the example above, for a TFSA to super-charge the power of compounding interest, the money needs time to grow.

Another practice that often has damaging consequences for long-term wealth building in a TFSA is the tendency of some investors to place speculative investments in these accounts.

This is potentially harmful for two reasons. First, as in other registered accounts, capital losses in a TFSA can’t be used to offset gains in unregistered accounts. Second, when you lose money in your TFSA with a speculative bet, you have permanently erased contribution room used to buy that investment.

There are a couple of other things to keep in mind when it comes to TFSAs.

As explained in this article, if you trade too much in your TFSA, the CRA could interpret this activity as an investment business. Under the tax rules, if the trading in your TFSA is considered as carrying on a business, you could be subject to income tax on the income. Separately, you should also be careful about planning what happens to your TFSA when you die.

Tax-free and the government are not usually terms that go together. When they do, you should make sure you’re taking full advantage. Maximizing your TFSA contributions for prudent, long-term growth just makes basic, good financial sense.

---

Be sure to listen to our Capital Topics podcast where François Doyon La Rochelle and I discuss important investing and personal finance subjects in terms everyone can understand. You can find it here or wherever you download your podcasts.