A Wealth of Choices: Understanding the New Tax-Free Savings Account

By RedFlagDeals.com Staff • Page 1 of 3

Last Updated: September 23, 2011

By Bennett Gold LLP, Chartered Accountants

Finance Minister Jim Flaherty called it the only significant tax-related savings plan since Registered Retirement Savings Plans (RRSPs) were introduced in 1957.

Many economists praised it as an affordable plan that will promote savings and help bolster the economy by providing more capital to corporations. And the Canadian Taxpayers Federation called it "an excellent policy proposal."

What is it? The new Tax-Free Savings Account (TFSA) that was the focal point of Budget 2008. The new account not only can help you save, it can play significant roles in your estate and tax planning.

Starting next year, Canadians aged 18 and older will be able to invest as much as $5,000 a year in a TFSA.

The new account is the mirror image of an RRSP -- contributions are made with after-tax dollars, rather than pre-tax money, but withdrawals are tax-free.

Withdrawals will add contribution room matching the amount taken out. In contrast, when you withdraw money from your RRSP you lose contribution room. In other words, if you withdraw $4,000 from your RRSP, $4,000 of your contribution room is lost forever.

The same investments eligible for RRSPs are eligible for TFSAs. So you can hold a number of income-earning holdings in the account, including equities, bonds, mutual funds, savings accounts, and term deposits. (See Page 3 for a closer look at the benefits of TFSAs.)

However, the point of the TFSAs is not to replace registered plans. In fact, all things being equal, the two plans are a wash as the table at the bottom of the article illustrates.

There generally would be no advantage to either a TFSA or RRSP, although both can provide a better rate of return compared with unregistered savings. The only difference is that with an RRSP you receive an initial tax deduction, which leaves you with more pre-tax dollars to compound over the years. The after-tax TFSA contributions mean you essentially have less money to grow.

Ideally, you would have both accounts and maximize their uses. Then you would have the flexibility to choose annually whether to pay tax on withdrawals from a registered plan. In some years you may want to keep taxable income low to minimize benefit clawbacks and in other years you may want some taxable income to account for losses.

What all this means is that you have some planning to do with your accountant before the TFSA is introduced next year to determine how the new savings account might fit into your retirement, estate and tax strategies. Here are several possibilities to consider...