Week 2 - Tax Free Savings Accounts

So I get the brainwave to start a blog. I didn't think i could wait an entire week to get a few more thoughts on paper... so here goes nothing. The first post with actual information!

If you work in Canada, odds are that you have a Registered Retirement Savings Plan (RRSP) of some kind, whether it's a group plan, locked-in plan or self-directed. Up until last year, this was really the only way to get tax-free growth for your own savings. We do have the RESP to save money for our kids' education but nothing else protected our personal investments from the tax man.

Then, the government threw us a big bone called the Tax Free Savings Account (TFSA).

TFSAs are accounts much like RRSPs. We contribute money to them, which can be invested in a wide range of things (stocks, mutual funds, GICs, etc) and we don't have to pay tax on any interest earned or capital growth. The great thing about a TFSA though is that we can get our money at any time without penalty AND if we have more money for savings down the road, we can recontribute it back into our TFSA. We don't lose the room the way we do if we take money out of our RRSP! Let me give you an example:

I put $5,000 into my TFSA each year (the maximum allowed) for the next 10 years, and it earns a decent return. After 10 years, my TFSA is worth $75,000. I decide that it's time to upgrade to a larger house, so I take my $75,000 and use it for a down payment. With the TFSA, I pay zero tax to take my money. And here's the kicker. The following year, I receive a one-time payment (maybe it was a bonus at work, inheritance, lottery win, etc) of $75,000. With the TFSA, I can actually RECONTRIBUTE the entire $75,000, plus an extra $5,000 since it's the following year. Here are the differences in summary between the two accounts:

RRSPs

- Tax deduction when we contribute

- Tax payable when we withdraw funds from the plan

- At age 71, account must be converted into an Income plan of some kind (RRIF, LIF, etc)

- Maximum annual contributions for 2010 are $22,000, plus any unused contribution room from past years (this is key for a great TFSA strategy outlined below)

- Beneficiaries can be named on the plan to avoid probate fees

TFSAs

- No tax deduction when we contribute, but

- No tax payable when we withdraw funds from the account

- No age limits and no mandatory conversions of the account

- Maximum contribution limit for 2010 is $5,000, plus any unused contribution room from last year

- In future years, the maximum amount is $5,000, plus unused room, PLUS any amount that has been withdrawn from the account in past years

- Beneficiaries can be named on the account to avoid probate fees

So with all that said, here is a great example of how to effectively use a TFSA, if you think you will earn a better employment income down the road. As mentioned, we can take money out of our TFSAs at any time, tax-free. So, if we are only earning $50,000 per year now, why not maximise our TFSA contributions each year until we are earning more money? Then, when we are making the big bucks, we can take all the money out of our TFSA and contribute it to our RRSP, getting a monster tax deduction because the tax rates are higher as our income increases. We should always try to contribute enough money to avoid paying tax at the highest rate. I understand that you might like the idea of a tax refund each year from RRSP contributions, but a little patience can go a long way in the event that you get a raise or a better job down the road. You still get the benefit of tax-free growth on the first $5,000 of savings each year, your unused RRSP contribution room will build up and you can get monster refunds when you are earning more money (getting a higher percentage of your tax back come tax time). Then when your RRSP contribution room is maxed, you can start recontributing to your TFSA to replace what you used for your RRSP.

You can Google "Canada Marginal Tax Rates" to find out how much tax you are on the hook for at your current salary.

Bottom line: everyone in Canada should have a TFSA, often even before we open an RRSP. It has the same great benefits of tax-free growth, while offering the flexibility of withdrawals at anytime.

I'd love to hear thoughts on this or any other. Drop me a line or leave me a comment!

Cheers,

GW