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Maybe you’ve got some extra cash lying around and you aren’t really sure what to do with it. You’ve heard about these Tax Free Savings Account (TFSA) things and don’t know what they’re all about. Here’s the scoop:

The Basics

A TFSA is essentially an investment account held at a financial institution, and the amounts contributed as well as the income earned (interest, dividends, etc.) are tax free, even when they are withdrawn. Anyone who is 18 years of age or older and has a valid Social Insurance Number can open one. Each year you can contribute a maximum of $10,000 to your TFSA, and this contribution room accumulates every year. Any withdrawals you make are added back to increase your contribution room for the following year, and contributions are deducted.

*Note: for 2009-2012, the annual limit was $5,000, for 2013 and 2014, the annual limit was $5,500 and for 2015 the annual limit is $10,000. The annual limit will return to $5,500 in 2016 and 2017.

The Pros

  • You can withdraw money from the TFSA at any time, for any reason, with no tax consequences, and without affecting your eligibility for federal tax benefits and credits.
  • Your Old Age Security (OAS) benefits, Guaranteed Income Supplement (GIS) or Employment Insurance (EI) benefits will not be reduced as a result of the income earned in, or the amounts withdrawn from, your TFSA. Meaning you won’t be slapped with a social benefits repayment if you make use of your TFSA funds and are receiving any of these benefits.
  • The income earned in the account or amounts withdrawn from a TFSA will also not affect your eligibility for federal credits, such as the Canada Child Tax Benefit (CCTB), the working income tax benefit (WITB), the goods and services tax/harmonized sales tax credit, or the age amount. Very, very good things as this allows you to maximize your tax return.
  • For estate planning purposes, the designated beneficiary rules apply to TFSA’s. Meaning that if you have a designated beneficiary assigned to your TFSA, the individual who receives the funds from your TFSA will not have to pay tax on that amount (as long as the payments don’t exceed the fund’s fair market value at the time of the holder’s death). In addition, if the individual receiving these funds wishes to invest them into their own TFSA, that individual can apply for an exempt contribution, which will not impact their TFSA contribution room.
  • If there is a marriage or common-law partnership breakdown, amounts can be transferred from one partner’s TFSA to the other’s, without any impact to either individual’s contribution room.

The Cons

  • The TFSA is not truly “tax-free”, its more “tax-free under most circumstances”. But, they probably didn’t call it that because it would make for a really messy acronym (TFUMCSA – meh, I’ve seen worse). Anyhow, there are certain situations under which the amounts earned in respect of investments in a TFSA are subject to tax. Briefly, these include, contributions made while you were a non-resident of Canada, and taxes on overcontributions, non-qualified investments, prohibited investments, and “advantages”. I won’t go into detail here as there are lengthy regulations around each. If you have a TFSA, or are considering opening one, give me a call and we can chat more about these. In addition, if these situations apply to you, you will also be required to complete and submit a TFSA Return to the Canada Revenue Agency.
  • The contribution room can be fairly low when compared with your RRSP contribution room.
  • The rate of return on the majority of TFSAs is relatively low (around 2% interest if you shop around). Deduct from that the trading fees that are charged if you want to use it to invest in equities for a higher rate of return (in theory…..we all know what the markets are like in reality right now) and you may not be walking away with much, if any, return.

TFSA vs RRSP

Sounds like a TFSA is a perfect savings vehicle for all, doesn’t it? I should stop contributing to my RRSP and use a TFSA right? Well, not necessarily. There are a few other factors to consider in the TSFA vs RRSP debate.

Unlike RRSP contributions, TFSA contributions do not reduce your net income. As a result, in the tax year in which you make the contributions, you will not have a reduced tax base (you’ll most likely pay more taxes than if you had’ve made RRSP contributions). This is a very important consideration for tax planning purposes, especially if you have a higher marginal tax rate.

But remember, any tax savings you realize today from an RRSP contribution, will have to be paid back down the road when you withdraw the funds. Of course, it can be argued that you would be paying that back at a reduced rate because your retirement income will be much lower than your income today. However, RRSP income can trigger clawbacks of your social retirement benefits, such as Old Age Security payments, if the income is high enough. If the withdrawals from your RRSP begin to reduce your social retirement benefits, not only are you paying tax on the RRSP income, you are also feeling the impact of reduced cash flow in your household. As you will recall (because I know you’ve diligently read through this entire post), TFSA withdrawals do not have any impact on social retirement benefits.

RRSPs offer the added benefits of being able to borrow your own money through the Homebuyer’s Plan and the Lifelong Learning Plan without tax consequences (just make sure you pay it back during the allotted timeframe!). Given the higher contribution room available with RRSPs, this is a great benefit.

Another point in the RRSP column, is that it they are in essence forced savings…who wants to take money out of their RRSP when they’ll be taxed on it? This can be very important for those of us who have difficulty saving.

An additional consideration is the wide use of employer-matched pension programs. If are one of the lucky Canadians out there who’s employer matches contributions to a company pension plan, contributing to that plan is definitely the better way to go. Who wants to turn down free money right?

You’re probably still wondering what the best option is for you…and the answer is – it depends. I definitely prefer the TFSA as a short term savings vehicle. But, the RRSP still has a lot of merit.

In general, for a very young, low income earner (less than $40K annually) with a low marginal tax rate, the TFSA can be the better way to go. The tax reduction provided by RRSP contributions really won’t benefit you all that much, and the TFSA will provide you with greater access to your funds for short term savings (vacation funds, etc.). However, for a middle to high income earner, the tax reduction benefit from RRSP contributions will be a huge benefit, making it more appealing.

A nice middle of the road option is to contribute to your RRSP, and then invest your tax refund in a TFSA. Using this option, the rate of return on your investment will be increased over straight TFSA contributions, you will be making use of the tax benefits that come into play with RRSP contributions, yet, you will still have funds available for use tax-free.

If you have any comments on this topic, or would like us to assess your situation, please e-mail us at info@af-cpa.com.