New Tax-Free Savings Account (TFSA)

There is a new tax free $5000 per year savings solution in the latest Canadian federal budget. The press regarding the savings account makes it sound like an RRSP alternative, but in actual fact it is very different. It is not a tax shelter in the most common sense of the term. While you cannot write off the income that you put in the savings account, the benefit is that you do not pay taxes on the interest earned in the account.

Essentially, the main benefit of the account is that it is a tax-free investment vehicle. This means that all income from the investment is tax-free, and in this particular case, all of the interest is tax free as well. This is a very very good thing because the income tax on interest is very high to begin with.

Another interesting point is that unlike an RRSP, any money you take out can be repaid without penalty. As an example, if you have been contributing for four years and you have $20,000 in savings and then you decide to withdraw that money to buy a car, that money can be repaid at any time without penalty. This means that the next year you could put $25,000 into the TFSA if you so wish.

The main points of the account are:

Unlike an RRSP, the TFSA does not lower your income for income tax purposes
Unlike an RRSP, the interest earned from the investment is not taxable
The contribution limit is $5000 per year
Any withdrawals can be repaid without penalty.

This option should be available to everyone in Canada in 2009 who is older than 18. This definitely creates an excellent option for tax-free savings.

Tax-Free Savings Account vs. RRSP

In time, if there are investment options that rival that of an RRSP (with similar interest rates) then the tax-free savings account may prove to be a vastly superior investment option in comparison to RRSPs.

To use as a comparison, $7150 (after taxes) invested in an RRSP vs a TFSA for 40 years at 10%:

To invest $5000 in a TFSA you would need to pay tax on it. At a 30% tax rate that would cost roughly $7150, or $2150 in taxes, assuming 30% taxation. Conversely putting $7150 into an RRSP would not result in any taxation, therefore $5000 in a TFSA would result in $7150 in an RRSP.

Here is where things get interesting. Over 40 years at 10% $5000 becomes $205,723.89, 40 years at 10% and $7150 becomes $294,185.16. Not bad eh?

Here is the real catch: if you took that money out of an RRSP, you would then have to pay taxes on it at whatever rate you took it out. For instance if you wanted to take it out over the course of 6 years at $50,000 per year, you would be paying taxes on it as if it were $50,000 per year income. Meaning you would lose about $15,000 per year, for a total tax payment of $90,000. Compare that with the TFSA where all taxes would have already been paid on the $205,723.80 and there is no more taxes to pay. It looks almost equal.

In short, the TFSA looks very promising. With a little luck, there will be investment options that will rival those in RRSPs and the rate of return could prove to be almost identical with a small catch. If you want to take all the money out at one time, it supports that without increased taxation (the taxation for taking $200,000 out of your RRSP in one shot would be about $90,000) and there is no fear in regards to taking it out early.

The TFSA looks to be a very good investment, not to replace RRSPs but to be used in conjunction with them. The benefit of being able to access the money tax-free at any time is great, and it could prove to be almost equal in terms of the tax benefits over the long haul.