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Monday, November 24, 2014

TFSA – Part II: Best Uses

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 At age 71, all RRSPs (and LIRAs) must be converted to RRIFs (and LIFs) and income withdrawn.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.

Comments

7 Responses to “TFSA – Part II: Best Uses”
  1. George says:

    There’s a third group of people who can benefit greatly from a TFSA: People with good pension plans. These people may not earn several hundred thousand per year, but because of the pension adjustment (PA), they may be very limited in the amounts they can contribute to an RRSP. For these people, a TFSA makes an excellent complement to an RRSP for retirement savings.

  2. rab says:

    What about this scenario. You retire early and will earn less than $40k/yr. between now and 65 when you intend to take your government benefits and start drawing from your RRSPs. I assume it would be a good idea to start drawing from the RRSP now and contributing the withdrawal to a TFSA. Presumably, the total income after 65 would be higher than the current income so it would be wise to redirect it to the TSFA. You might have to pay some tax on the RRSP withdrawal now but it would be less than when the other income kicks in at 65. Does that sound reasonable? Or am I missing something?

  3. Jon Snow says:

    I’m one of those with a good pension plan who hasn’t really been able to contribute much to an RRSP thanks to the pension adjusment. So yes, the TFSA is vital for my retirement plan…

    This year, thanks to some carry over, I’m able to contribute $19000 to my RRSP and I think I can JUST manage that.

  4. Robert says:

    George and Jon: I agree that anyone with little RRSP contribution room can benefit greatly from a TFSA. You’ve given an excellent real-life example, thank you.

  5. Robert says:

    rab: I’ve provided the link to the tax brackets. If your tax bracket will be higher in retirement, moving assets from an RRSP to a TFSA, paying the taxes along the way, will probably be best. However, keep in mind the “age amount” deduction, pension income deduction and pension income splitting that are available after age 65.

    If you don’t mind taking risk, you could “melt down” your RRSP using leverage (investment loans). I generally recommend against it, but if you retire early and are willing to go back to work if everything blows up, it could save tax.

  6. CPS says:

    I look forward to the next article about assets in TFSAs.

    In agreement with what George said about pension plans. Specifically ones with that large severance pay at the end. You need to save up some room in an RRSP to put that in there to avoid paying to the taxes, so in the interim, putting money in the TFSA is a great way to go.

  7. Melanie says:

    I prefer a TFSA instead of an RRSP because I work for the government, as and as such am entitled to a defined benefit pension plan. Because I am contributing a solid amount of my pay, with employer match, it doesn’t necessarily make sense to put more money in a tax-deferred savings plan. It makes more sense for our family to max out the TFSA and max out my husbands RRSP contributions.

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