Problem 1: What is the Best Way to Save for Retirement? (50 marks)

Derek Ha will save $5,000 p.a. every year for 10 years. At the end of the 10 years he will convert his savings to an ordinary annuity that pays an equal amount at the end of each year for the next 10 years. The annuity interest rate is 4% p.a. His marginal tax rate during the first 10 years will be 40%. His marginal tax rate during the 10 years when he is receiving the annuity will be 25%. He has three possible plans for the account he saves the money in.

Plan 1

He deposits the $5,000 into an RRSP. He deposits the tax refund amount into a TFSA. Both accounts earn 6% p.a. for the entire 20 years. Assume the deposit into the RRSP and the tax refund deposit into the TFSA occur at the end of the year. He then buys a 10 year annuity at an interest rate of 4%. For the taxation on the TFSA, see the note in Plan 2.

Plan 2

He deposits the $5,000 into a TFSA at the end of every year, earning 6% p.a. At the end of 10 years he buys an annuity for 10 years at an interest rate of 4% and pays the tax on the annuity each year. The taxation of the annuity income when it is funded with the money from the TFSA is complicated. I asked for an expert opinion on whether you could invest in an annuity inside a TFSA and the answer is unclear. I think you can do so if it is a term certain annuity, but I am not sure if you could do so if it is a life annuity. For this question we will assume that you can buy the 10 year annuity inside the TFSA and hence you will pay no income tax as you withdraw the annuity payments.

Plan 3

He deposits the $5,000 into an unregistered (taxable) account and invests it in a portfolio of common shares that pay no dividends. The value of the shares grows at 6% p.a. for 10 years. At the end of 10 years he sells all the shares and pays the tax owing, at a marginal tax rate of 40%. Then he buys the 10 year annuity. You would pay tax only on the interest portion of each payment during the 10 years. Chapter 18 shows you how to do this most efficiently, using a prescribed annuity.

Required

What is the annual amount of the annuity after-tax under each of the three plans?

What does this tell you about the best way to save for retirement and why?