Tax-Free Savings Accounts (TFSAs)… A Closer Look

The Financialist • Issue 98 • July 2008
BY DAVID CHALMERS BA FLMI CLU CFP RFP ChFC

In our April 2008 edition of The Financialist, we introduced you to Tax- Free Savings Accounts. Here is a very brief review of "the rules".

Starting in 2009, all Canadians over 18 years of age will be allowed to deposit up to $5,000 a year (adjusted for inflation to the nearest $500) to a TFSA. If you don't make your maximum contribution, you can carry it forward and make it in a subsequent year.

Contributions are not tax-deductible; however, all investment earnings within a TFSA will be tax-sheltered and all withdrawals will be tax-free (and will not count as income when determining the Old Age Security clawback). When you make a withdrawal, you are allowed to re-deposit the amount of the withdrawal to your TFSA (in addition to your regular deposit allowance).

So, taking all of the above into account, should you have a TFSA ?

With one caveat, I believe the overwhelming answer is "yes". Let's examine that caveat.

Any financial institution that is an issuer of a TFSA (at this point there aren't any) will have an administrative burden. The plan will have to be registered with the government and the issuer will have to track deposits and withdrawals. Thus, we may see issuers charging some form of administration fee.

You will save tax if you have a TFSA. If there is an administration fee for having the plan, you want to make sure that the tax savings exceed the cost. This should be the case... but one should do the analysis (with the help of your friendly financial advisor) before proceeding.

Now, let's look at the tax savings. Let's assume that you like to keep a floating balance of $20,000 in your bank account. Your financial advisor has most probably already suggested that you keep this money in a high yield account. While we don't know the future direction of interest rates, today one could reasonably expect to earn about 3.25% per year. That's about $650 a year of interest.

One has to pay tax on interest income at one's "marginal tax bracket". If we assume that your marginal tax rate is 30%, then you'd have to pay $195 per year in tax. It would take you four years (at $5,000 per year) to get this $20,000 into a TFSA. Having done so, you would be saving $195 per year in tax. (If the administration cost for the TFSA were $60 per year, then the whole transaction makes sense. If you only ever made a single deposit of $5,000, it would not make sense to have the TFSA).

Should you stop at $20,000? The answer is no. You should continue putting in as much as you can.

Let me, at this point, prioritize a couple of items. In most cases, you should make your maximum RRSP deposit before making a deposit to a TFSA. The RRSP deposit gives you both a tax deduction on the deposit and tax-sheltered growth.

If you have "non-deductible debt", you should pay down the debt before making a deposit to a TFSA. (After all, you would be paying the interest on your debt or mortgage with after-tax dollars).

If you have no debt, you're making your maximum RRSP contribution, and you have additional money to save, it makes sense to save as much as you can in a tax-sheltered environment.

However, if you are in a low income tax bracket and expect to remain so during retirement, it may benefit you to contribute to a TFSA rather than to your RRSP. This is because withdrawals from your TFSA will not affect your income-tested government benefits in retirement.

If you are going to earn interest, it makes sense to try to earn that interest within a tax-sheltered environment. Therefore, my expectation is that many people will tend to hold savings accounts, money market funds or guaranteed investment certificates within their TFSA’s.

There is also a completely contradictory school of thought. Some advisors will recommend that you make high-risk investments where there is a potential of a large gain within your TFSA. (Of course, as a prudent financial advisor, I must point out that any investment that has the potential of producing a large gain also has the potential of causing you to realize a large loss, too). The theory with the "high-risk approach" is that you get to take all the money out of the TFSA tax-free... if your investment happens to pay off.

In the year 2009, we'll be discussing TFSA's with each of our clients in determining whether it makes sense to have one (we expect, in most cases, the answer will be “yes”). We'll also determine the most appropriate investment strategy for you to follow.