RRSPs and TFSAs and Margin Accounts… Oh My!

Piggy BankI would like to demonstrate in this post what I think is a pretty fair comparison between the three types of accounts, and why in my opinion, it is most likely better to just go with a straight-up Margin Account strategy and pay the taxman what she wants every year, as opposed to doing what everyone assumes you should be doing, which is, avoiding paying as much tax as possible on your investments. Remember, if the bank or government is telling you you should be doing something a certain way, it is almost certainly with the goal of making money at your expense!

For those non-Canadian viewers (or newbies!), a few quick definitions:

  • RRSP (Registered Retirement Savings Plan) – Basically, a deferred taxation account. Idea being, when you are younger and making higher wages (my assumption below is you are in the 40% tax bracket when you contribute) you can contribute to your RRSP and use it as a tax write off, so you get 40% back of whatever you contributed. The trick is, you pay tax on it later in life, but the idea is you make less then, so you pay less tax. I’ve assumed you pay 20% to cash it in when you are old, which puts you in the $50K/year tax bracket, probably fairly accurate in my opinion.
  • TFSA (Tax Free Savings Account) – An account that you contribute to, and any profits made in there are not at all taxed.
  • Margin Account – An account that you put money in, and the institution loans you up to (approximately) an equal amount of money that you can use to invest if you wish. So put $10K in there, and you can buy $20K worth of stuff (stocks, etc). Obviously the borrowed money comes at a cost!

I recently opened up an RRSP account with scotiaitrade.com because I had to, because back before I got smart about stuff, I had some RRSPs, but then I bought a house and borrowed that money as a first-time home buyer to make the down-payment, and so now I have to pay it back to an RRSP every year over the next 15 years. Hence the analysis. Unfortunately it is not possible to open an RRSP/TFS account (at least at scotiaitrade.com) that also gives you the benefits of a Margin Account (the lending aspect of it, that is). If any readers know of another institution that does do that, do tell because that would blow my entire analysis to pieces!

So a few assumptions I made below:

  • The RRSP contribution is made when you are taxed to the max – 40% per year for our purposes here
  • The RRSP is cashed later on in such a way that you are only paying 20% tax on the money
  • You reinvested the money you got back on your tax return the year you contributed into your RRSP
  • You pay 4.5% to borrow money on your margin account (which is what I pay on mine, at the moment)
  • Capital gains tax is 20% on half of the profit, as is the case in Canada

With these assumptions as you’ll see in the charts below, it turns out 6.5% annual ROI (return on investment) is approximately the point where Margin Accounts start to overtake RRSPs. From there, any annual extra gravy causes Margin Accounts to sky rocket above RRSPs, exponential style. TFSAs don’t appear to be at all worth the time to even talk about.

Without further adieu, let’s take a look at what making 7% per year in each of the three types of accounts looks like:

RRSP vs. TFS vs. Margin @ 7%

RRSP vs. TFS vs. Margin @ 7%

7% per year is actually surprisingly easy to make, and surprisingly safe to assume, once you’ve decided to take your finances into your own hands, and stop trusting the so-called professionals (I say that from all the mutual fund nightmares I’ve heard about over the years, among other horror stories such as my own bank’s line of RRSPs they offer).

How to make a safe 7% per year? Dividends. Especially dividends from buying REITs (Real Estate Investment Trusts). For example, this one (A quick google search on mREIT will give you a list of others that offer a similar return near the 7% mark). Buying a REIT behaves exactly like buying a stock from the investors point of view, except there are laws in place to ensure dividends are higher. As usual though, the higher the dividend, the less likely the value of the REIT itself will go up or down. That is why it is safer. (Hands waiving in the air)

What does 12% per year look like, which to me with a little bit of luck and a little bit of work is very much achievable? (see How I Made $12,000 in Seven Months Without Working to find out how I made a 25% return in only 7 months)

RRSP vs. TFS vs. Margin @ 7%

RRSP vs. TFS vs. Margin @ 12%

Now we are getting somewhere!

What about a Warren Buffet rate of return? (They say 20% per year is roughly somewhere around his lifetime average)

RRSP vs. TFS vs. Margin @ 20%

RRSP vs. TFS vs. Margin @ 20%

Hot damn. Good thing he didn’t listen to his banker and invest in a *safe* 3% per year RRSP like mine suggested to me. Obviously a regular Joe like you or I cannot expect to average returns like that every year, but the example nicely illustrates the trend!

And so if you are fairly lazy when it comes to taking care of your investments as are most people (and your stats are similar to what my above assumptions are), an RRSP is the way to go since you probably won’t do any better than 6.5% without trying. TFSs don’t ever seem to be the better choice according to my calculations (if someone knows something about why that is not the case, please tell us!). And with only a very small amount of time to educate yourself on the matter (like, clicking on a couple of the links above), the Margin Account starts to tip the scale. Add a little more research time, some portfolio diversification, a tiny bit of optimism and a good dash of luck, and you’ll be retiring much, much earlier than you ever would have thought possible!


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4 Responses to RRSPs and TFSAs and Margin Accounts… Oh My!

  1. Pen says:

    You can put in $5500/year and invest the money in whatever you want. The contribution amount is cumulative, so if you have some catch-up room, this really isn’t bad, since all the money you earn in that account is tax free and it’s your to with what you wish. The annual contribution is supposed to go up to $10k/year, but don’t know when. It’s a good place for a nest-egg.

    • mzungu says:

      Right. Playing around in my spreadsheet once more, I see earning less than 5% per year is the tipping point where TFSAs become the better way to go over my Margin Account method.

      And so I suppose if you are in the same tax bracket while working/saving as you plan on being in when you retire (thus making the TFSA better than the RRSP), and you don’t expect to make more than 5% per year on your investments, the TFSA is the way to go.

      The problem is, I just demonstrated how easy it is to make a minimum of 7% (by being a REIT). So really there is no reason to ever use a TFSA :)

  2. Andrew says:

    The problem with RRSPs is even worse if you have income other than what you are taking out of your RRSPs… that drives up your marginal rate during “retirement” and you get heavily taxed at your personal income tax rate, even if what was in your RRSP was capital gains!

    On the other hand… “easy to make 7%” makes me laugh. Its easy only if you’re not risk adverse. The market can be really punishing. I was up 20% last year, and then the wind changed and suddenly I was up only 5%. And that’s only because in a couple of cases I acted fast and got out of things before the going got really ugly. If you really don’t expect to need your money for 20-30 years, go for it… that decade window should let you roll out of high risk investments into safer vehicles, if you’re savvy enough to have good timing and presence of mind. If you need your money any time soon though, the market will just give you ulcers!

    • mzungu says:

      Great points about the RRSPs – it is true, you better hope to not be making money anywhere else if you plan on cashing one of those puppies, otherwise all gains could be lost! Which to me is just silly… I plan on “retiring” (am I retired now??) LONG before I plan on ceasing to earn money from all other sources. And I hadn’t even thought about the fact that that RRSP could be turning your capital gain into regular income. That makes it really ugly.

      It is also true that the market can give a person an ulcer if they’re not careful :) I guess being in my mid-thirties, I feel like I’m still young enough to be going for those higher risk maneuvers. That said, I don’t necessarily see buying up a bunch of REITs and sitting on them as all that risky. Whether the market is up or down, the dividends still keep a comin’…

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