I suppose I’m like most people right now. I woke up to this new world where everything has changed and no one told me. Ah, federal budgets gotta love them.

So unless you’ve been avoiding the news and have yet to read a single blog you might have come across the term of Tax Free Saving Account (TFSA). What the hell is it? Well in a nut shell it’s very similar to an RRSP, except without the tax deduction. So starting in 2009, each person over 18 can put away $5000 a year into these types of accounts (which the contribution limit does grow with inflation in increments of $500). Savings grow tax free and so are withdrawals. Here’s the kicker, when you pull money out you get back your contribution room (unlike a RRSP) and you get to carry forward contribution room even if you don’t use it in that year.

Now must people have been thinking “O great I can put my saving for my high interest savings account in there so I’ll save a tax on my 4% interest of $5000 which works out to a max of $80. Who cares?” People give your heads a shake and realize the huge potential of these accounts!

It is $5000 per person per year indexed to inflation. That means in 15 years my wife and I will have $150,000 in contribution room, which assuming I have maxed out means I could be pulling out $6000/year (assuming the 4% rule) tax free between the two of us for our early retirement and not affect any benefits I would receive from the government when I turn 65!

Wait it gets better. You can buy spousal accounts too! So now we have additional way to income split. So I can put $5000 a year for each my wife and me to theses accounts ($10,000 in total/year). Then the money grow tax free until we pull it out to use it for anything we want at any time and when we do we just get more contribution room.

Just imagine what would happen to someone turning 18 and working until 65. They can invest tax free a total of $235,000 over their working career and keep all the gains from 47 years of compound interest tax free when they pull them out! Assuming a 4% real rate of return that money would end up being $696,316 in their TFSA which would be making $27,853 per year in returns(in today’s dollars). You could take out the entire amount at 65 and not pay a dime in tax and still qualify for the GIS program (assuming they had no other income from CPP or pensions)!

So when you combine the TFSA with RRSP’s we now have a combination that can do wonders. Let’s say I put in $14,285 per year into pension and RRSP’s. That gives me a refund of $5000 (assuming a 35% tax bracket). Then I put that in a TFSA each year until I turn 45 at real rate of return of 4%. That would give me $109,123 in tax free money sitting around (in today’s dollars). I can then take the basic tax deduction for both my wife and I of $10,100 (for 2008) each out of my RRSP’s with no tax. So that’s a total of $20,200 and then I can top that up with $5000 from my TFSA to make a total of $25,200 with NO TAX AT ALL! Effectively the government has just given me a way to ensure I don’t pay a dime of tax during my early retirement! Mmm, perhaps I need to adjust my plan and see if I can’t retire a bit earlier now!

Or there is another way to think of this account. Imagine for a second you have a small sum of cash to invest and you put into some risky non-dividend paying stocks. Typically rapid buying and selling would be a good way to lose your money because fees and taxes. In a TFSA there are no tax consequences, so suddenly we have a nice new toy for day traders if you get some cheap fees (like $5/trade).

Obviously there are going to be questions like can I transfer in an existing investment? Will the banks charge fees on these accounts and how much? You get the idea. We will have to wait for some more details, but in the mean time check out the official document here (see page 76, I’m still reading it for other interesting details).

Despite the doubts over this when you put the TFSA with RRSP’s and RESP’s we now have a set of policies that actually encourages people to SAVE. If nothing else I thank the government for that.

This post is now part of the 143rd Carnival of Personal Finance.

Thanks for the link. I’m enthusiastic about these accounts and think the nay-sayers are missing the point here.

Great post Tim, some good clarifications & examples here. I’m excited too!

Great post.

Just for the record – the tax refund money is not “tax free”, you have still paid income tax on it. Regardless, a combination of RRSP & TFSA (if you have enough money) will help for retirement savings.

Mike

Can you simplify this and compare it to an RRSP..pros and cons?

Mike,

Actually I was referring to the fact the money you get back on your tax refund from an RRSP contribution is the amount of tax you would have paid on that money. So if you add your original contribution and your tax refund together that money is equal to paying no tax on it. Hence my term ‘tax free’. I can see the possible confusion, so thanks for the note.

CM,

Mmm, the easiest way to think of the two of them is this:

1)RRSP- You get a refund of the tax you paid on the money when you put it in. Then you get taxed when you pull it out.

2)TFSA- You don’t get a tax refund when you put it in, but then you don’t pay tax when you pull it out.

In either case the money grows tax free. Otherwise they are almost twins except for a few minor issues.

I hope that helps,

Tim

Is there any age or income limit to contribute to a TFSA? Would my kids be able to have TFSA’s that I could contribute to?

Dmallett,

Yes. You have to be over 18 and they only start in 2009.

Tim