Tax-Free Savings Account (TFSA) – How should we use it?

The only reason I need these gloves is ’cause of my hands. – Yogi Berra

2009 brings one exciting new development – TFSAs. You may have seen a bunch of news coverage about them. We consider them to be the best new retirement savings vehicle since RRSPs. For many, perhaps most Canadians, they will be better than RRSPs.

Here is the scoop on what they are and how we should be using them.

First of all, it is pronounced “TiFSA”. The easiest way to explain them is that they are exactly like RRSPs except for 4 differences:

• The main difference is that you do not get a tax deduction for contributing and you do not pay tax on any withdrawals.
• Everyone 18 and over (no maximum) can contribute up to $5,000/year, regardless of income.
• Any amount you withdraw, you can recontribute the next year (or any time after that).
• There are no spousal TFSAs, but you can contribute to your spouse’s TFSA.

Other than these 4 differences, they are exactly like RRSPs.

How should we use them? There are 3 options:

1. Use them like your RRSP and max both (Best use) – If you can afford to max both the TFSA and RRSP, you should do that and invest them both similarly for the long term. For us financial planners, this will provide lots of tax planning opportunities after you retire. We can effectively determine your tax bracket by how much we withdraw from each.
2. Use either TFSA or RRSP for your retirement savings, depending on your situation (2^nd best use) – If you cannot max both, then you need to determine which is best for you and use. If it is TFSA, then invest it like you invest your RRSP now with long term investments.
3. Use them for short term savings/emergency fund (Last resort use) – If RRSPs are better for you and you cannot afford both, then using a TFSA for you savings account is a reasonable use. The long term tax savings should be many times higher if you invest in long term investments, even if they are tax-efficient.

How do you determine whether TFSA or RRSP is better for you?

The best way to figure it out is to compare your marginal tax rate now to what you think it will be when you withdraw, presumably after you retire. For example, if you are in a 40% tax bracket now and you expect to be in a 20% bracket after you retire, then RRSPs are better for you. You will get a $4,000 tax refund from a $10,000 contribution, but only have to pay $2,000 tax in retirement when you withdraw it.

The issue here is that there is a common misconception among Canadians that almost everyone will be in a lower tax bracket after they retire. The truth is that probably about half of Canadians will be in higher tax brackets after they retire. The reason for this is all the clawbacks on income for seniors.

In Canada, we like to provide income for seniors, but then take it away if they have other income. Therefore, seniors face clawbacks in addition to income tax – 50% on the GIS (part of Old Age Security but for very low incomes), 15% on the age credit, 15% on Old Age Security and 5% on GST income.

The end result is that the top tax bracket in Ontario for those under 65 is 46% on income over $121,000, but seniors that earn either under $22,000 or over $37,000 will be in even higher tax brackets between 43%-72%. Can you believe they tax some low income seniors at 72%?

The short answer, then, is that if you expect your retirement income to be either very low (under $22,000) or moderate to high (over $37,000), then TFSAs are probably better for you than RRSPs.

The other big issue is what you use your tax refund for. If you spend your tax refund, then TFSAs will be better for you. However, if you have an important use for your tax refund, such as contributing it to an RESP for your children’s education, then the RRSP may be better. Contributing to a TFSA will not give you that tax refund.

In most cases, a combination will be best. This will mean that you would retire with a large nest egg both in an RRSP and in a TFSA, which gives us great control in minimizing your taxes by deciding exactly how much to withdraw from your RRSP (or RRIF) and how much to withdraw tax-free from your TFSA.

Ed