TFSAs: Not a simple decision

Individual investors usually hold investments with the biggest tax cost in TFSAs. Assume John has $5,000 excess cash to invest, for example. He would gain the greatest advantage by putting the fixed income in his TFSA. But the same may not hold true for private corporations.

The analysis becomes more complex when you can control your income. If you’re a private business owner or incorporated professional, you can choose to leave capital in the corporation and invest corporately, or pull the capital out of the company and invest personally.

Say an incorporated dentist pays herself dividends instead of a salary. For her to have $5,000 available to deposit in a TFSA, her corporation would need to pay her a larger dividend because she would need to pay personal tax on that dividend. Looking at the 2015 top effective marginal combined federal and provincial rates of 30.84% and 40.13% for Alberta and Ontario, respectively, a dividend of $7,229 or $8,351 would be required. This leaves the shareholder with the following choices:

• retain a larger amount in the corporation, pay corporate tax on the accumulation and eventually pay personal tax on the withdrawal; or
• pay the dividend now, pay the applicable personal tax currently and invest the net amount in a TFSA.

Corporations pay a high, fixed tax rate on passive income (46.17% in Ontario, 45.67% in Alberta and 33% in both provinces on dividends). Some of this corporate tax is refundable through the refundable dividend tax on hand (RDTOH) account, but that only occurs when a taxable dividend is paid to the shareholder (i.e., a $1 refund for each $3 of taxable dividends paid, up to the account balance). In Ontario, it appears that corporate accumulations of dividend and equity portfolios are more efficient when left in the company, rather than drawn out and deposited in a TFSA. But it’s not that simple, because it depends on the amount of return and how long the money will be invested for. In John’s case, compare the value of the TFSA after 10 years of $5,000 annual deposits in a fixed-income investment to the after-tax value of a similar investment held corporately.

For example, using an expected return of 4%, the TFSA’s value would be $62,432, while the after-tax value of a similar corporately held investment would be $59,582. The TFSA value divided by the corporately held investment equals 104.8%. Whenever the value is above 100%, the TFSA is more advantageous. Whenever the value is below 100%, holding the investment corporately is more advantageous.

We analyzed whether the province’s tax rate makes a difference, and whether high (6%) or low (3%) rates of return make a difference. We found that fixed-income investments always produce better results when accumulated on a tax-sheltered basis in a TFSA. The provincial tax rates don’t significantly impact the analysis.

We also analyzed dividends. In a high-return (6%) scenario, dividend returns in a TFSA are slightly disadvantaged until year 14 (high province) or year 19 (low province). But the TFSA is a better vehicle than the private corporation, if the investment is held longer than 14 or 19 years.

A portfolio that’s expected to produce only low returns (3%) is better held in the private company than a TFSA, but only by about 2% over the long term.

We considered investments that return only capital gains. For ease of analysis, we assumed that the capital gains were realized annually, incurring the associated income tax liabilities. Generally, capital gains shouldn’t be held in a TFSA. If you’re a private business owner or incorporated professional, a more detailed analysis of your personal situation is needed to achieve long-term results.