The Tax-Free Savings Account (TFSA): An Alternative to the RRSP

The TFSA is a registered savings vehicle that has been available since 2009. It allows you to accumulate investment income that is not taxable. The TFSA's tax advantages are as enticing as those offered with RRSPs, and its eligible investments are similar to those available for RRSPs (mutual funds, guaranteed investment certificates, bonds).

Anyone age 18 or over can contribute to a TFSA. There is no maximum age limit, income requirement, maturity date or minimum withdrawal requirement.

Annual TFSA contribution limit

• From 2009 to 2012: $5000
• From 2013 to 2014: $5500
• For 2015: $10 000
• From 2016 to 2018: $5500
• From 2019 to 2022 : $6000
• For 2023: $6500
• For 2024: $7000

Unused contribution room carries over to the following years and accrues interest. Any withdrawals of capital and interest become new contribution room as of the following year. Note that amounts reinvested during the same year could result in excess contribution, and the excess amount could be subject to a tax penalty.

Taxation

• Contributions cannot be deducted from taxable income.
• Annual investment income is tax exempt.
• Withdrawals are not taxable, and they have no impact on benefits from social programs [e.g., Guaranteed Income Supplement (GIS), Old Age Security (OAS) pension and employment insurance].

TFSA or RRSP, which should you choose?

People with higher incomes can now contribute to both a TFSA and an RRSP. For other people, the best choice depends on comparing the tax savings on your RRSP contributions with the expected tax rate for withdrawals in retirement.

The following table compares the after-tax value of an RRSP with that of a TFSA. We have assumed a tax savings of 45% for the RRSP contribution and estimated the net RRSP value at 3 different withdrawal tax rates.

The TFSA is comparable to the RRSP if the tax savings for your RRSP contribution deductions equal the tax rate on your withdrawals (as in Example 2: 45% deduction rate, 45% tax rate). In this case, the net values are identical at $17 639 after 20 years.

The TFSA is preferable for short-term and medium-term projects. Specifically:

• It is ideal for setting up an emergency fund, for example, for students looking to build their savings while their financial situation is not stable.
• Contributing to a TFSA is also a good idea in the long term if you expect the taxes on your RRSP withdrawals to be higher than the tax savings on the initial contribution. Example 3 shows a net value of $14 432 after 20 years (lower than the $17 639 for the TFSA) with a tax savings of 45% and a tax rate at withdrawal of 55%. This could be the case for low-income retirees whose GIS income is reduced as a result of RRSP withdrawals. This situation may also apply to certain retirees affected by OAS pension clawbacks.

The RRSP is preferable for long-term projects, especially if the tax rate on your RRSP withdrawal will be lower than your tax savings on the initial contribution. This is the case for most people who contribute to an RRSP, with the new rules for income splitting with your spouse playing a big role. As shown in Example 1, the net value of an RRSP ($20 846 after 20 years) could be higher than the value of a TFSA ($17,639) because the tax savings on the initial contribution (45%) could be higher than the tax rate at withdrawal (35%).

If you're not sure which option is right for you, a TFSA is probably your best bet. Here are some other factors to consider:

• Amounts in an RRSP are protected in the event of bankruptcy.
• You can pledge a TFSA.
• In general, TFSAs are not part of the family patrimony.
• Though you cannot contribute to your spouse's TFSA, funds you give your spouse to contribute to his or her TFSA are not subject to attribution rules.

The TFSA is advantageous for many people with higher incomes who have already maxed out their RRSP contributions and for less wealthy investors who manage to put aside a little money.

Talk to your financial planner about the TFSA's many legal and financial aspects and how they could affect you and your estate.