Disclaimer: The following content, while believed to be accurate, should not be relied upon without the advice of a financial professional.
RRSPs (Registered Retirement Savings Plan) and TFSAs (Tax-Free Savings Account) are legal tax shelters that have been created by the Canadian Government to help people save for their retirement. All kinds of investments can be made using cash that is in these accounts. Banks, Stock brokers and other institutions offer these accounts to investors.
An RRSP allows you to take pre-tax income and invest it without first having to pay tax on it. All investment gains and dividends in an RRSP accumulate within the RRSP without any taxes being applied. However, when cash is taken out of an RRSP (which can be done anytime), that withdrawal is treated as regular income and is fully taxed at your marginal tax rate (top rate is 53.5%) and you can’t re-contribute that withdrawal. Regular income tax is payable on the entire withdrawal (not just on the gain). When you reach the age of 71, you are required to start withdrawing a federally prescribed percentage each year. Ideally, when withdrawals are made, your marginal tax rate is at a lower rate than before.
A TFSA allows you to take after-tax income and invest it. As with an RRSP, all investment gains and dividends in a TFSA accumulate within the TFSA without any taxes being applied. However, when cash is taken out of an TFSA, that withdrawal is not taxed at all. There is no required withdrawal at retirement age. As an additional feature, you can also take cash out tax-free at any time and then re-deposit that amount in future years. The amount you can contribute to a TFSA is presently only $6K/year but if you haven’t set one up, you can contribute $81,500 (in 2022). Contributions to an RRSP can be higher and are based on a percentage of your income. Another factor is timing. When you retire and withdraw from an RRSP, your marginal rate may be lower than when you contributed.
Which is better? Technically, there’s no difference between these accounts in terms of net financial benefit (see example below) although they provide investors with different investment strategies. It behooves investors to take maximum advantage of BOTH RRSPs and TFSAs, especially since there are limits as to how much you can contribute annually to these accounts. An RRSP will allow you to invest more up-front (since you’re using before-tax income) and then pay taxes when you cash in, whereas with a TFSA, you invest after-tax income and then pay no tax when you cash in.
Investment companies offer such accounts on a managed basis – i.e. they manage these accounts for investors or they can be self-directed whereby the investor manages what is held in these accounts.
As for what you can put into these accounts, shares of publicly traded companies are the most common. Legally, you can also put non-publicly traded securities into these accounts provided that your account manager (Trustee) is willing to do that. For example, you can put shares of a private company, such as a technology startup, into these accounts. You can also hold WUTIF shares in an RRSP. Many banks and brokers will not accommodate that for you (it’s a hassle for them). However, there are trust companies that are not only willing but very keen let you do this. Many WUTIF investors use Western Pacific Trust Company to hold WUTIF shares in an RRSP. WUTIF can facilitate this for investors.
Suppose you invest $100K in a start-up company that might become a huge success and you get 10 times your money back. Normally you’d pay about $240K in capital gains taxes when you cash in. But, if that investment were held in a TFSA, you’d pay NO tax! Alternatively, if you used an RRSP, you could invest almost twice as much, say $200K of pre-tax income giving you double the gain but then you have to pay regular income tax when you withdraw funds from your RRSP. In both cases, the net benefit is the same.
However, if the startup is a Canadian Privately Controlled Corporation (CCPC) you can take advantage of using the Lifetime Capital Gains Exemption (LCGE) so it makes no sense at all to use a TFSA or RRSP unless you’ve used up your LCGE. For 2022, the LCGE is set at $913,630. Although the LCGE does not apply to WUTIF, WUTIF has been able to redeem shares on a tax-free basis by using its CDA account. Because of this, using a TFSA or RRSP may not be advised. However, there is no assurance that these tax-free payouts will continue indefinitely.
TFSA vs RRSP Financial Comparison
EXAMPLE: USING AN RRSP TO INVEST $10K IN WUTIF
Let’s say you made a $10K investment in a start-up that has doubled to $20K. If you hold this personally, then you’d pay a dividend tax of 49% on your gain of $10K giving you a payout of $15.10K on an investment of $7.00K (because you got $3K tax credit when you invested). If you hold this inside an RRSP and then take the cash out, you’d get a payout of only $9.30K on your $7.00K net cost. That’s because when you take the $20K out, you pay tax of 53.5% on the entire $20K – not just on your profit. That’s a BIG difference – $15.10K personally vs $9.30K using an RRSP.
However, this isn’t a fair comparison because you’re not taking advantage of using pre-tax income. If you use an RRSP, you’d be investing pre-tax income which means that instead of having $10K (post-tax) to invest, you’d have slightly more than double that amount to invest. So the main advantage of using an RRSP, is cash flow – you would have more cash available to invest. Even better, using both the RRSP & VCC Tax Credit, you can invest 4X as much – i.e. $40K (Because you get a $20K RRSP tax credit and a $12K VCC tax credit). Without the RRSP, you could only invest $14K (because you get back $4K). So, if WUTIF’s share price doubles in 5 years, you’d get $80K in the RRSP instead of $28K outside of the RRSP. If you take the $80K out of the RRSP, you’d get $37.20K (because you pay tax of 53.5% on the entire $80K). On the other hand, on the $28K held personally, you’d pay a dividend tax of 49% on your $14K gain, giving you a net payout of $21.14K. For the same starting amount (i.e. $10K after tax or $20K pre- tax income), you’d end up with $37.20K in your pocket using an RRSP vs $21.14K by not using an RRSP. This is because the RRSP lets you invest more to start with (i.e. income before it’s taxed).
As a further thought, lets say that the share price stays the same and does not double. When you redeem the shares personally, you’d get back your original $10K investment (you’d still have a $3K profit – i.e. tax credit) but if you take the $40K out of the RRSP, you’d have $18.6K in your pocket plus your original $12K tax credit giving you a PROFIT of $20.60K! Without the VCC tax credit, you could only invest $20K using an RRSP and if the share price stays the same, and you withdraw the funds from the RRSP, you’d end up with exactly the same $10K (after tax). The VCC tax credit makes the use of an RRSP very attractive.
EXAMPLE USING A TFSA TO INVEST $10K IN WUTIF
If you invest $10K using a TFSA, you still get the $3K tax credit. If the shares double, you can take $20K out of the TFSA tax-free! If you hold the shares personally, as per the above example, you’d get a $15.10K payout. So clearly, using a TFSA appears to be better (remember – you have less to invest at the outset). Unlike an RRSP, you don’t get any up-front tax benefit. If you compare a TFSA with an RRSP the after-tax results are identical as shown above.
As long as WUTIF can use its CDA to redeem investors’ shares on a tax-free basis, there is no reason to use a TFSA. Using an RRSP may still make sense because you can start with 4 times the amount due to the VCC tax credit. For those investors who intend to hold WUTIF shares for a very long time, multiple rollovers (for additional tax credits) provide even more benefits.