When switch from ‘Taxable-to-tax-free (TSFA)’ and ‘High-to-Low MER funds in taxable accounts’ makes sense?

In a nutshell

Selling and re-investing after-tax proceeds in the same or similar stock funds can be a ‘no-brainer’ when going from taxable to tax-free (TFSA) accounts. However when switching from high-to-low MER funds within a taxable accounts additional considerations come into play, such as: the tax on the unrealized capital gain, expected long term return of the fund, the difference in MER between the high (old) and low (new) cost fund. Old rule of thumb of fixed income assets into tax-deferred and tax-free accounts while stocks into taxable accounts may no longer be operative (though still applies to tax-deferred accounts). Since the future is unknown, tax-diversification is also advisable.

The details

Back in 2008 when TFSAs were launched in Canada, in the Contribute to RRSP or TFSA? 401(k) or Roth 401(k)? Tax-free or Tax-deferred? post I suggested that the simple answer to whether a TFSA (tax-free, much like a Roth IRA in the US) or an RRSP (tax-deferred, much like a IRA or 401(k) in the US) is the appropriate retirement vehicle for an individual, is that one should pay the tax when one’s tax rate is lower. (Again, keep in mind that I don’t consider myself a tax expert by any means. Before you decide to implement any of these recommendations you should do your own research and/or consult a tax expert; if you disagree, I’d certainly appreciate to hear from you.)

So if you expect to be in a lower/higher tax bracket in retirement than you are now, then an RRSP/TFSA is respectively more appropriate retirement savings vehicle. But there are all kinds of additional considerations which might lead to situations which may push one into higher tax brackets in retirement (especially when OAS clawback kicks in, which by the way is triggered off ‘Net’ rather than ‘Taxable’ income so previous capital losses are excluded): those expecting to have large tax-deferred (RRSP) accounts there are minimum withdrawal requirements to consider or if one’s income is expected to grow rapidly (e.g. young professional). In such situations perhaps a tax-free (TFSA) account where tax has already been paid on contributions might be advantageous (i.e. use first). But when the employer matches contributions in an RRSP (tax-deferred) account, then it is likely appropriate one to use at least to harvest the employer contributions (i.e. use first). However low income Canadians who expect to be eligible for the Guaranteed Income Supplement (GIS), will find that retirement savings from after tax dollars, i.e. using TFSAs, would reduce the possibility of being disqualified for the GIS.

Still, the greatest imponderable may in fact be what the uncertainty of future tax rates until and in retirement (e.g. tax rates/brackets and/or income related benefit adjustments). Given this unknown it may make sense to go for “tax diversification” and split your investments between tax-deferred and tax-free accounts, so that during retirement you will have the flexibility to select from where you draw your income depending on tax and other income considerations.

Also, the general rule of thumb used to be is to put interest bearing (and non-Canadian dividend paying stocks), which are taxed higher than capital gains, into tax-deferred or tax-free accounts to minimize taxes, whereas stocks, since they deliver capital gains, should be in taxable accounts.

What has changed since 2008 when TFSA was introduced?

Many things changed since the introduction of the TFSA:

-interest rates on guaranteed instruments dropped from about 5% to about 1-2%

-TFSA contribution limit has increased from $5,000 to $10,000/year

-widely available investments of all types with dramatically lower management fees/expenses

So the tax owing on $10,000 earning 1-2%/year would be < $100/ year. On the other hand, if you can earn capital gains of 6-8%/year over the long term you can double your money every 10 years or so and before you know it the tax owing on the capital gains (in taxable or tax-deferred accounts) can add up to some real money. So it is well worth exploring potential advantages of putting stock funds into TFSAs and interest bearing instruments into taxable accounts.

A no-brainer?

Many investors feel trapped with high cost investments (MERs=1-3%) in taxable accounts when they have accumulated substantial capital gains over long periods of time. They are reluctant to switch to lower cost investments of the same type because the switch would incur substantial taxes to be paid immediately.

Assuming investor’s tax rate on capital gains is constant, then selling and re-investing after tax proceeds in the same or similar stock fund may be a ‘no-brainer’ when going from taxable to TFSA (tax-free) accounts (when cost of funds is the same or lower). However when switching from high-to-low MER funds within a taxable account additional considerations come into play, such as: the tax on the unrealized capital gain (a function of the tax rate and percent of market value which represents unrealized capital gain), expected long term return of the fund, the difference in MER between the high and low cost fund .

Within a tax-free or a tax-deferred account the switch to lower cost securities is simple, as long as there are no penalties to pay, it makes sense to switch to similar lower cost securities. Typically, these are no brainers, much like moving higher return rate funds from taxable to tax-free accounts, where the benefits start in year 1. (Just make sure that if you are moving (or selling and re-investing in) the identical securities on which you have capital losses from a taxable to a TFSA account, you should wait for 30 days so your capital loss won’t be disallowed. This should not be an issue in case of gains, as you’ll have to pay tax on those upon sale.)

As indicated earlier, in a taxable account the decision is more complex. You get an idea of how the various factors mentioned above can affect the after tax difference between an existing fund in a taxable account and the same/similar fund in a TFSA (i.e. tax-free) account or switching to a lower cost (MER) fund within a taxable account. You can observe some of the effects in

Tax impact taxable vs TFSA and MER

In Graph 1 above a security is sold in a taxable account and the after-tax proceeds are re-invested in a similar security but with a lower MER but still in a taxable account; in this example the impact of MER differences of 1.32%, 0.82%, 0.57% and 0.32 % are compared (e.g. a fund with MER= 1.5% is replaced with one having MER=0.18%). The difference in outcomes (new vs. old) is examined for a $100K market value in the original fund which includes $50K unrealized cap gain, 6% return and 30% cap-gain tax rate (includes OAS clawback). The after tax difference after 25 years ranges for $50K to -$12K.

Graph 2 above compares the effect of various levels of unrealized capital gain embedded into the original fund. As expected the greater the unrealized gain, the higher the associated initial tax and the lower the reinvested assets. But for a 1.17% difference in MERs shown here between the old and new funds can be substantial after 10 years even when unrealized gain at starting point is 75% of market value.

Graph 3 shows the enormous effect of moving a fund from a taxable account to a tax-free (TFSA) account for a long term investor. After 25 years in this example the after-tax difference in outcomes ranges from $100K-$160K for the original $100K pre-tax market value of the fund.

I have included a simple spreadsheet to allow you to explore whether in your situation it makes sense to execute such a switch in a taxable account and the expected benefit from moving a stock fund into a TFSA (i.e. to replace previously used fixed income investments). (Speaking of spreadsheets in a very interesting recent Financial Times article to following spreadsheet statistic was quoted “a widely circulated figure is that 5.2 per cent of numerical or formulaic cells contain an error. From this follows the estimate that 94 per cent of spreadsheets contain errors.” Hopefully, this spreadsheet does not have errors, but there are no guarantees; please let me know if you find a problem.)

The following figure shows the simple spreadsheet with the required inputs. The output is in graphical form and it shows the benefits (or lack there-of) of the switch. The required inputs, given that current investment is in Fund A and target new investment with the after-tax proceeds from selling Fund A is Fund B. The required inputs shown in red are:

Fund A: Cost basis and Current Market Value, Cap-Gain tax-rate and Current MER

Fund B: New fund MER, and Cap-Gain tax-rate

Expected Future Return (Funds A and B are similar asset types so are expected to have similar/same returns except for the drag associated with the different MERs.

Fund B- Fund A calculator

Bottom line

Re-evaluate the old rule of thumb which would suggest that TFSA (tax-free) account is for interest bearing securities while equities are to be kept in taxable accounts. (The old rule of thumb still applies to RRSPs vs. taxable accounts.)

Moving stock funds (even with substantial capital gains) from taxable to TFSA (tax-free) account the after-tax benefit can be immediate due to two factors: all future gains and dividends will be tax free and future returns will be higher due to lower cost of (similar) funds.

Consider whether it makes sense for you to replace high cost funds with lower cost ones, not just within tax deferred and tax free accounts, and moving from taxable to tax-free accounts, but even within a taxable account when you have substantial capital gains and paying associated taxes payable in taxable accounts; it all depends on embedded unrealized capital gain, the tax-rate, the expected return and the MER (fund cost) before and after the switch.

Try the spreadsheet on your example; it is relatively simple to use.

Tax rates may increase or decrease for tax-free, tax-deferred and taxable accounts, so tax-diversification should be considered by most.

(Note that this discounts the undesirable outcome that may occur if stock/fund sold in the taxable account at substantial capital gains tax, drops significantly after placed in the tax-free account, because we didn’t get the tax benefit of the loss in the taxable account. But this is a timing the market issue, which as we know is not something that the most investors are good at. So assuming that you plan to hold

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