Question

Please provide complete step-by-step explanation. Thanks!

Jack and Jill are in the highest marginal tax bracket in Ontario and have maxed-out both their TFSA and RRSP. They have no more room in either tax-shelters and are in the 54% marginal tax rate on ordinary income and interest income and 27% on all realized capital gains. Now, assume Jack decides to invest $100,000 in a stock based mutual fund that earns a constant 5% pre-tax, but the fund is highly inefficient and realizes the entire return in capital gains every year. In contrast, Jill invests $100,000 in an extremely tax-efficient stock based mutual fund that earns a constant 4% pre-tax in unrealized capital gains each-and-every year. Both Jack and Jill withdraw – and plan to spend – the money from this account (“taxable bucket”) in 10 years. Question: Who has more money on an after-tax basis? Jack or Jill? Make any assumptions you think are necessary to answer this question, but that do not change the nature of the question.

Answer 1

Following Assumptions have been made in the given scenario

1. In the given scenario, Jack and Jill have maxed out their contributions in TFSA (Tax Free Savings Account ) & RRSP (Registered Retirement Savings Plan), so no more investments can be made in any tax saving instruments and any income from further investments will be taxed at Marginal Tax rate i.e.. 54%.

2. Jill has invested in Stock based Mutual fund where the capital gains are unrealised every year and hence it is assumed that it will have compounding effect on post tax income.

3. It is also assumed that there are no expenses incurred out of the Income from above Instruments and ancillary income of above instruments.

4. Capital Gain on Investment made by Jack is earned at year end and available for investment in the next year.

5. Interest Income on Further Investments earn 5% p.a. and is earned at year end only. Thus the same will be available for investments only in the next year.

6. The Amounts have been rounded to zero decimal for the sake of brevity.

7. There is no Tax on Unrealised Capital Gains on Investment made by Jill and Tax is levied only in Year 10 and there is annual compunding of Interest.

A. Total Amount with Jack at Year 10

Steps for Calculation

1. There is a constant return of 5% ie $ 5,000/- pre tax and $ 3,650 post tax, which is available for further investment at the year end.

2. There is no interest earned in year 1 on the capital gain earned.

3. The Surplus available for next year will be Post Tax Capital Gain + Post Tax Interest Income.

Jack	Principal Amount	Capital Gain @ 5%	Tax on Capital Gain @ 27%	Capital Gain Available for Further Investment	Surplus Invested	Interest Income on Further Investments @ 5%	Tax on Interest Income @ 54%	Surplus Available for Investment in Next Year
Year 1	1,00,000	5,000	1,350	3,650	-	-	-	3,650
Year 2	1,00,000	5,000	1,350	3,650	3,650	183	99	7,384
Year 3	1,00,000	5,000	1,350	3,650	7,384	369	199	11,204
Year 4	1,00,000	5,000	1,350	3,650	11,204	560	302	15,112
Year 5	1,00,000	5,000	1,350	3,650	15,112	756	408	19,110
Year 6	1,00,000	5,000	1,350	3,650	19,110	956	516	23,200
Year 7	1,00,000	5,000	1,350	3,650	23,200	1,160	626	27,384
Year 8	1,00,000	5,000	1,350	3,650	27,384	1,369	739	31,664
Year 9	1,00,000	5,000	1,350	3,650	31,664	1,583	855	36,042
Year 10	1,00,000	5,000	1,350	3,650	36,042	1,802	973	40,521
Total		50,000	13,500

4. 1. The Total Amount available with Jack is $ 1,40,521

On the basis on Annual Compounding at 4% p.a. Jill will have $ 1,35,048 post tax as follows

Principal	1,00,000
Capital Gain Pre Tax	4%
Tax Rate	27%
no of years	10
Amount Realised at Year 10 (Annual Compounding Basis)	1,48,024
Tax on Above	12,966
Amount at Year end	1,35,058

Thus, in case of current scenario and based on above assumptions Jack will have more money.