TFSA vs. Taxable Account: Should You Trigger Capital Gains to Fund Your TFSA?

Despite my gentle protests, he insisted, when I asked if he had “x”, that he’d order and stock it because, he declared, “If you’re asking, there are nine other people who want it, but aren’t letting on!” Informed by this wonderful little life lesson, perhaps you are one of the proverbial other nine people who has wondered about the following tidbit, but hasn’t asked.

The TFSA Dilemma: Invest $100,000 Taxable or $90,000 Tax-Free?

When chatting with a client recently, the question arose about whether it makes economic sense to fund a TFSA contribution by pulling the necessary capital from a taxable Nexus account if doing so triggers a big taxable capital gain. In the heat of the moment, it occurred to me that if a $100,000 withdrawal would leave only, say, $90,000 for the TFSA after providing for capital gains taxes, maybe it’s better to forgo the TFSA contribution, not incur the capital gains tax bill, and simply let the $100,000 continue to grow in the taxable account. I hit “pause” and told the client I wanted to do some analysis – to assess how many years it might take for the $90,000 in the TFSA to grow before it’s worth more than the $100,000 in the taxable account, assuming both accounts are invested the same (and grow at the same rate).

How I Analyzed the TFSA vs. Taxable Account Trade-Off

To work this out, I resorted to Excel – my favourite analytical tool. (The old adage is true: when you have a hammer, a lot of things look like a nail.) It’s not a difficult financial modelling exercise. But to do the tax-related math on the taxable account accurately, there is some work to properly capture the effects of reinvested income and capital gains distributions from our Equity Fund, and the payment of quarterly investment management fees.

Why the TFSA Almost Always Comes Out Ahead

The short answer is this: Making reasonable assumptions, and unless the capital gains taxes are huge, it’s almost always better to trigger them, and contribute the after-tax proceeds to a TFSA. You’re better off, not just in the long run, but almost right away.

The reason has partly to do with the fact that the periodic distributions of fund income are taxed every year in a taxable account, but never in the TFSA. And it also has to do with the fact that management fees are deductible annually for tax purposes for the taxable account, but never for the TFSA.

But the big thing is capital gains tax. One way or another, it has to be paid on the taxable account. To be sure, as long as the capital remains invested, that tax bill can be deferred – both the amount that relates to the unrealized capital gains accumulated so far, but also to the future growth in those gains. In the contribute-to-TFSA scenario, the tax on the taxable account’s hitherto unrealized capital gains gets paid more or less at the time the capital is pulled out and contributed to the TFSA. But the capital gains from then on accumulate in the TFSA and, as a consequence, never get taxed.

The Bottom Line on Funding Your TFSA

So, when it comes to making your TFSA contribution – whether the annual $7,000 amount, or some big “catch-up” amount (for missed contributions in the past or to recontribute funds previously withdrawn) – run, don’t walk. Pull what you need from your taxable account and contribute it to your TFSA. Incidentally, a corollary to this analysis is to leave your TFSA capital intact and growing, rather than dip into it simply to avoid triggering capital gains taxes on your taxable account.

If this tidbit brings to mind other questions, ask ‘em. As that grocery store owner from my past would say, there are undoubtedly many others who are wondering the same!