Posted by Tim Stobbs on January 14, 2010
Because of the way Tax-Free Savings Accounts work, they don’t make sense for everyone. Just because you will have more TFSA contribution room this year, doesn’t mean you need to make a deposit. I will lay out some situations where making a TFSA deposit will generally result in financial benefit.
The first group who is likely to benefit from TFSA contributions is people with under about $40,000 of annual income. The first tax bracket ends around this level. You can find the exact amounts at: http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html. Young people with income below this amount may expect to have greater earnings in future. If that’s the case, they could make a TFSA contribution now, and save their RRSP contribution room until they are in a higher tax bracket and it will result in a larger refund. In fact, they could even use TFSA money to make RRSP contributions later. Here’s an example: Jerry is a student, working a co-op semester. His income for the year is $25,000. If he made an RRSP contribution of $5,000, he could expect a tax refund of about $1,250. if he put the money instead into a TFSA, then waited until his first year of full-time work, he might be earning $50,000 per year. He could then withdraw the money from the TFSA (let’s assume it’s still $5000) and contribute it to the RRSP, earning a refund of $1,670.
The next group that will benefit from TFSAs is those who have a very high income and can complement full RRSP contributions. RRSP room equals 18% of the previous year’s earned income, with a maximum of $22,000 for 2010 (see: http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/cntrbtng/lmts-eng.html). If a person earns over $220,000 in a year, they will only be able to contribute 10% of thier income to their RRSP. A TFSA will afford them some limited additional room for tax-free savings. Other tax shelters for the wealthy include leverage, life insurance and income splitting, often with a corporation.
People over the age of 71 can find themselves in a similar position. At age 71, all RRSPs (and LIRAs) must be converted to RRIFs (and LIFs) and income withdrawn. The purpose is for the government to begin to collect the taxes that have been deferred. If the minimum withdrawal is greater than the retiree wants to spend, they can put the money back in a TFSA. Taxes must still be paid, but future growth or income is now tax-free.
A TFSA is also ideal for short-term or medium-term savings. Some examples might be an emergency (or rainy-day) fund, funds for a vacation, funds for a car or a downpayment for a house. If one were to save for a vacation, by making RRSP contributions, they would pay taxes on the full amount withdrawn and also not regain the RRSP room that was used. If they saved for a vacation outside of an RRSP, they would need to declare any income earned on their taxes each year. A TFSA is both more efficient and simpler. There is a program under the RRSP called Home Buyers Plan, that makes allowance to withdraw funds for a downpayment for a home. However, there are many rules that must be respected. Some examples include: neither spouse has owned a house in the five previous years, and withdraws must be paid back 1/15th each year over the next 15 years, or taxes paid. TFSAs have none of these restrictions and funds can be saved for any purpose.
If you have debt, you can have some of the benefits of a TFSA, without the restrictions. As an example, Angela has $10,000 of personal debt at 7% interest. If she has $8,000, she could put it in a savings account at 5% in a TFSA and pay no taxes on the interest income, but only if she has available contribution room. If she pays $8,000 toward her debt, she will avoid paying 7% interest. That savings is, of course, not taxable and puts her ahead financially. If the loan is revolving, such as a line of credit, she can borrow the money back if she needs it again. Assuming the TFSA would have held a savings account and the credit remains available, repaying debt is financially preferable to making a TFSA contribution.
TFSAs are most useful for people who have no debt and either have low income or high income and no RRSP room. If, like the majority of people, you have debt or pay taxes in the middle tax brackets, you may still find a TFSA useful for short or medium-term savings. Next time, we’ll look at strategies when deciding which assets to put in the TFSA instead of an RRSP or open investment account. In the comments, please share whether or not a TFSA makes sense in your situation.
Robert is a Certified Financial Planner (CFP®) in Calgary who develops financial plans and also gives objective advice regarding all types of savings and investment products. He believes that not having money worries can allow people to spend their time in other meaningful areas of their life. Robert is married, has three children and is involved in his church, in his community association and in the school. Robert is on track to retire at age 42, although he and his wife plan to change careers and work for the benefit of children.