The new Tax-Free Savings Account (TFSA) is a great new vehicle - but what does this mean for your good'ole registered retirement savings plan (RRSP)? Many Canadians may be tempted to chose the TSFA over their RRSPs starting in 2009 - so let's take a sober look at all this.
There's plenty to like about the TFSA: You can achieve tax-free growth inside the plan, there is no tax on withdrawals, you don't need to earn income to be entitled to contribute $5,000 annually (if you're 18, have a social insurance number, are resident in Canada, and are breathing, you pretty much qualify), you can carry forward unused contribution room for future use, if you make withdrawals you can put those dollars back into the plan later without a penalty or needing to somehow create more contribution room - and so on.
The point is that a TFSA should be used by everyone. You'd be hard pressed to think of any exceptions. Sure, the dollar amounts that can be contributed are pretty low today, but that contribution room will accumulate over time, and you can bet your bottom dollar that these limits will be increased in the future, even beyond the modest increases for inflation that have already been promised.
Now, did the Department of Finance intend for TFSAs to be better than, or to somehow replace RRSPs?
No. In fact, if you crunch the numbers, it's pretty clear that you'd likely be indifferent between using a TFSA or an RRSP. Check out the table. If you earn $5,000 this year and want to save that money, the table shows what you'd have after 20 years in the case of both the TFSA and the RRSP, assuming a 7-per-cent annual pretax return, and a 40-per-cent marginal tax rate. As you can see, there would be no advantage to either.
So, how do you choose between a TFSA and an RRSP? If your primary objective is saving for retirement, I like RRSPs. The tax on withdrawal often provides a psychological barrier to spending those retirement dollars prematurely. Making withdrawals from the TFSA is going to be far too easy for my liking - if you really care about saving for the long term. In addition, you're not going to be able to save enough in a TFSA alone for retirement - not at this stage, given the low contribution limits. Finally, if your marginal tax rate is expected to be lower in retirement than when you put the money into the plan, the number crunching in the table could actually favour RRSPs.
Having said this, I like the flexibility of being able to decide, on a year-by-year basis, whether or not to pay tax on withdrawals from a savings plan. In some years you'll want to keep taxable income down (to minimize clawback of government benefits, for example), but in other years you may want taxable income (to use up losses or for other reasons). And so, having both a TFSA and an RRSP will make good sense. It's all about flexibility later. There will be much more to say on this as we approach 2009.
Comparison of TSFAs to RRSPs
Tax-Free Savings Accounts versus Registered Retirement Savings Programs.
| TFSA | RRSP | |
| Pretax income | $5,000 | $5,000 |
| Tax owing ( % ) | $2,000 | $- |
| Net contribution to plan | $3,000 | $5,000 |
| Value of account after years* | $11,609 | $19,348 |
| Tax on liquidation ( % ) | $- | $7,739 |
| Cash in your pocket | $11,609 | $11,609 |
Assumes a 7% annual pre-tax return
SOURCE: THE WATERSTREET GROUP INC.
