Saturday, November 15, 2008

Tax-Free Savings Accounts (TFSA)

Effective January 1, 2009 Canadians will be able to save up to $5,000 per year in an account and have this money grow on a tax-free basis. Contribution room will be added each year for any contributions not made. As money is needed for purchase of a home, education, retirement, or any other lifestyle needs, funds can be withdrawn on a tax-free basis.

This withdrawal also creates "re-contribution room," allowing your total potential pool of tax-free savings to never be depleted. At death, the entire account can be paid out free of tax as well. That's the quick version — grow tax free, withdraw tax free, re-contribute withdrawals, and pay out at death tax free.

Should you put your money into an RRSP or a TFSA?

First you need to determine your tax rate now and your anticipated tax rate during the withdrawal phase. If the two tax rates are identical, the TFSA is better option because it is more flexible and withdrawals do not affect income-tested benefits.

I suspect that most of you will fall in the category where your tax rates in the accumulation phase are higher because you are in your peak earning years and are paying the highest tax rates of your working life. Presumably, when you are retired you will be paying much lower taxes. Since your contribution tax rate is much higher than the withdrawal tax rate, a RRSP contribution is likely to be the better option. For the few Canadians who pay a higher rate in their withdrawal years than in their contribution years, a TFSA is probably the superior option.

However, a TFSA is a great vehicle to use to put 3 to 6 months of savings in to use for unexpected expenses. A TFSA can hold any investment vehicle that you can hold in an RRSP.

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