Understanding the Tax-Free Savings Account (TFSA)

In the 2008 federal Budget, Finance Minister Jim Flaherty, announced what he considers will be historical significance in introducing Tax-Free Savings Accounts (TFSA). Previous to the introduction of TFSAs, saving money could be done either in an RRSP or a non-registered savings account. The newly announced TSFA is a mix between an RRSP and a non-registered account.

RRSPs are attractive because you get an immediate tax deduction for the contribution and any investment earnings are tax sheltered as long as the money stays in the RRSP. On the other hand, the downside of RRSPs occurs when you take money out because you then have to pay the tax.

With a TFSA, you do not get a deduction when you put the money in but you also don't have to pay tax when you take the money out. Similar to the RRSP, you do not have to pay tax on any investment earnings in the TFSA giving you the benefit of tax sheltered investment growth.

TFSA versus RRSP

The new debate is the TFSA or RRSP.  With the TFSA, on $5000 contribution, you will save $50 to $80 in the first year of contribution from tax sheltered growth. Critics of TFSAs suggest that's not enough benefit to entice people to save and while that may be true, how would you feel if you found $50 on the ground today. I bet it would make your day. I'm of the opinion that any amount of money saved from taxes is in your best interest!

When you compare the benefit of the TFSA with what you would get if you invested in the RRSP, the TFSA may not be as attractive because the RRSP would give you $1250 to $2000 in tax savings from the initial tax deduction.

However, you can't properly compare TFSA with the RRSP by just looking at the tax savings going into the plans. You also have to look into the future when the money comes out of the plans. With the RRSP any withdrawal is fully taxable. That means a withdrawal of $1000 might only net you $600 to $750 after tax depending on your marginal tax rate. With the TFSA if you take out $1000, you get the full $1000.

The bottom line is RRSPs still make sense if you are saving long term for retirement and your income at the time of withdrawal is in a lower tax bracket than your income at the time of contribution into the RRSP.  As much as the TFSA has great appeal, TFSAs will not replace the RRSP for retirement savings.  In fact, it may be best to do both.

TSFA vs non-RRSP

TSFAs have a clear advantage over non-RRSP savings. Let's look at an example of Tony and Nick who both have $5000 to invest. Tony puts his $5000 into a TFSA compared to Nick who puts money into a non-RRSP savings account. After 10 years based on a 5% return, Tony would have $8144 compared to Nick who only nets $6985 after paying tax on the investment earnings. Rick is ahead by $1159 after 10 years. After 20 years on a single $5000 deposit, Tony would be ahead by $3508.

The more money Tony puts into the TFSA, the bigger the further ahead he will be over Nick over any time frame. For example, if they invest $5000 per year instead of a one time contribution over 20 years, Tony would be ahead by $32,391.

My Two cents

Overall, I like TFSAs. I can definitely see where I will use the TFSA in my own personal financial plan. Even after writing this article I can see lots of planning for many different people younger and older.

My hope is the TFSA will encourage people to save more money instead of going into more debt. I think TFSAs might be used more as short term spending accounts rather than long term savings accounts but only the future will tell us how TFSAs actually get used when they become available in 2009.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

4 Responses to Understanding the Tax-Free Savings Account (TFSA)

  1. Hi Jim, We opened TFSA’s Jan 1 2009 and contribute monthly. My husband is now in a much higher tax bracket then before so we withdrew a large sum from his and made a spousal RRSP contribution, and then next year we will do it again but we will also increase our monthly TFSA contr. to his plan. This way we have $ on hand for any emergencies, and since I am in a low tax bracket the TFSA will be good for the future too. What do You Think of this plan? Thank-you.

    • I think the TFSA is a great place to accumulate money until you have decided what you want to do with it. RRSPs are more long term investments. Once you put it in, there are tax consequences to get it out where it is easier to get money out of the TFSA.

      For people who are not disciplined, putting money into the TFSA can turn into a spending account. In other words saving to spend vs saving for your financial future. In that case, sometimes it’s better to have the monthly contributions go right to the RRSP.

      It sounds like you are disciplined so congratulations!

  2. Its obvious no one should use a TFSA before maxing out their RRSP. Anyone who puts savings into TFSA just to have it accessible loses too much to taxes up front. With generally equivalent rates of return on RRSP and TFSA’s thats all people need to know.

  3. I think TFSA is extremely important as we get into our retirement years. The main purpose I find after investigating, is it’s use to lower the amount you will have to take out of your RRSP’s, which are taxable.
    The reduction of one’s RRSP use will in turn help as you withdraw CCP and OAS which of course are both taxable.
    If a couple solely relies on RRSP withdrawals, they could be financially penalized on both CPP and OAs if too much RRSP funds are drawn based on the government clawbacks. It may be extremely to utilize non taxable income as well as taxable to income to secure the most from the CPP and OAS programs.

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