Taxes are the rigged cat-and-mouse game between citizens and CRA in which the cat always wins. And it’s imperative that it does, because a welfare state relies on the proper cycling of taxes. But it doesn’t make it easy on investors when they have to carve out a massive chunk of what they make to give to CRA in taxes. So how can investors make the best out of this situation?
The answer is fairly simple: By using the tools provided by the government. TFSA and RRSP are two tax-deferred accounts created for the very purpose of allowing Canadians to invest and grow their wealth. From the two, TFSA is completely tax-free in nature, while the RRSP is tax-deferred.
Deciding which one of these two is better to dodge the CRA greatly depends on your income. If you are making less money now, TFSA can be your tool of choice. But if you are making more, RRSP can be the better pick.
The case for TFSA
Let’s say you are earning $60,000 a year. After taxes, you are looking at a little over $50,000. As TFSA contributions are not tax-deductable, you will be paying the whole tax bill, even if you max out your contribution for the year.
If it were, you would have saved $1,000. But with that sacrifice comes the power of growing your wealth without any tax implications in the future. Now you have to choose the right stock.
When you are employing the power of time and compounding, the dependability and growth of your dividends might be more important than the yield.
Fortis (TSX:FTS)(NYSE:FTS) therefore looks like a good stock to put in your TFSA. It’s the second longest-standing Dividend Aristocrat on TSX as it increased its payouts for 46 consecutive years. Also, as a utility company, it’s relatively recession-resistant.
The company has also shown decent growth. Its CAGR for the past five years is 7.71%. The current dividend yield is 3.31%, but given the company’s dividend history, your payout will most likely grow in the future.
If you invest $30,000 of your TFSA in Fortis, and in each year’s contribution, allot $3,000 for shares in Fortis, you will earn somewhere around $290,000 in 30 years through dividends alone.
Your capital growth will be somewhere around $600,000, at a conservative estimate. In total, you will have earned about $900,000 in 30 years, by putting half your TFSA in Fortis, totally tax-free.
The case for RRSP
If you have a much higher yearly income, then the tax-deferred RRSP might be the one for you. Say you have a yearly income of $100,000. If you make the maximum contribution in your RRSP ($18,000), you will save around $3,950 in taxes. In 30 years, provided your income and tax numbers remain the same, you will have saved about $118,500 in taxes.
If we pick the same stock for your RRSP as well and buy $30,000 of Fortis stock in your RRSP, it will grow the same way, and you will have a nest egg of around $900,000 sitting in your RRSP in 30 years. You can then convert your RRSP to RRIF, but you will still have to pay taxes on the amounts you withdraw from your RRIF.
This is why, if your income is high, it’s important to grow your wealth as much as you can in your RRSP. You have the power of compounding, and if you pick the right stocks, you can be sitting over a few million while you retire. Then, even with a hefty tax bill, you will have enough saved up to enjoy a comfortable retirement.
This is an example of how, based on your earning, you can choose one account over the other to grow your wealth, with minimum tax implication. You can also use those accounts differently to meet your short term and long term goals.
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Fool contributor Adam Othman has no position in any of the stocks mentioned.