A Canadian's random thoughts on personal finance

Mar 30, 2008

Who wins with the new Tax-Free Savings Account?

The pundits are all over the new Tax-Free Savings Account (TFSA) introduced this week in the federal budget. They seem to want it to be complex and ambiguous, but it's actually pretty simple.

In an RRSP, you save your money, it grows tax-free, and then you withdraw it and pay all your taxes at the end. Who benefits from paying taxes at the end? Well, anyone who will be in a lower tax bracket when they withdraw the money than when they earned it.

In a TFSA, you pay tax on your money at the beginning, then you save it, and it grows tax-free from then on. Who benefits? Those who will be in a higher tax bracket when they withdraw the money.

Well, who in the world would be withdrawing their money at a higher tax bracket than when they earned it??
  1. Twentysomethings living at home with a low-paying job and even lower expenses. By their mid-30s, they may be in a pretty high tax bracket, and now they can grow their savings tax-free and withdraw it tax free. For instance, their TFSA (which could be as much as $80k) can be plunked down as a downpayment on their first home with no repercussions whatsoever. That's four times as much as the RRSP home-buyer's plan limit, and without the forced repayments.

  2. Low-income earners nearing retirement. Benefit "clawbacks" can put these people in a tax bracket of almost 90%, making an RRSP completely infeasible because they'd lose almost 90% of their savings. That means the lowest-income people are, ironically, the ones who can't make use of the tax-free compounding of RRSPs. The tax-free compounding of the TFSA puts these people on an even footing with richer Canadians.
In other words, the TFSA is encouraging two groups of people to save who ordinarily don't save very much. Sounds good to me.

Others probably won't benefit a whole lot from the TFSA. I guess people with too many investments to fit into their RRSPs—a very nice problem to have—can move some of the least tax-efficient ones (interest-earning investments like bank accounts and bonds) into the TFSA.

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