A better RRSP?

When the federal government announced that it will launch a new tax-free savings account next year, most finance experts yawned and asked the feds to keep it down until they had some interesting news.

After all, these new accounts (called TFSAs for short) seem much like the RRSPs we already have — but not as good, because you don’t get a juicy tax refund when you contribute, and you’re allowed to put in only $5,000 a year. Most experts concluded that TFSAs may be handy for saving up for a house or new car, but won’t be able to handle the heavy lifting required for retirement savings.

However, when Malcolm Hamilton, an actuary at the consulting firm Mercer in Toronto, took a look at the fine print, he found that wasn’t true. “If people understand TFSAs properly, significant numbers will start using them,” he says. They’re so powerful, in fact, they could eventually become Canada’s retirement saving vehicle of choice.

How is that possible? Because despite appearances, the TFSA has most of the benefits of an RRSP — plus some powers that RRSPs lack.

The key benefit of both accounts is that they allow you to avoid paying taxes on your investment gains as long as your money remains in the account. In that respect they are identical. This tax-free compounding can put you tens or even hundreds of thousands of dollars ahead over long periods of time and it’s the prime reason for using such accounts.

The biggest apparent drawback to contributing to a TFSA is that you don’t get an immediate tax refund, the way you do with an RRSP. The tax refund seems to give RRSPs an edge, but it turns out it’s only half the story.

Many people forget that when you take money out of an RRSP you have to pay taxes on it. So if you’ve amassed $100,000 in an RRSP, and you expect to retire in the 40% tax bracket, you really have only $60,000 to spend. But with the TFSA, what’s in the account is yours, tax free. If you have $100,000 in your account, you have $100,000 to spend.

It’s true that you’re limited to contributing $5,000 a year to a TFSA, which is much less than you could potentially stash away in an RRSP. But Hamilton argues that the TFSA is more generous than it first appears. Because unused contribution room is carried forward, if someone who is 18 today starts saving for retirement when she is in her late 30s, she’ll find she already has $100,000 of TFSA contribution room.

Plus, the TFSA packs a secret power: any withdrawals from a TFSA account don’t trigger clawbacks on government income. That means you can get full Old Age Security (OAS) and Guaranteed Income Supplement (GIS) payments from the government when you retire, no matter how much you withdraw from your TFSA.

If you save up for retirement with an RRSP, when you retire and start taking money out, you not only have to pay taxes on your RRSP income, but lower income Canadians who receive the GIS could see it reduced, and higher income Canadians who receive OAS could see clawbacks. However, if you use a TFSA, there’s no tax and no clawbacks on any government money. You could pull down $80,000 a year from your TFSA in retirement, but pay zero taxes on that amount and still get maximum government benefits.

So which account should you use? It depends on your income bracket. Low-income Canadians will find that the TFSA is clearly the better choice, because they rely more on government benefits. Middle-class Canadians will find that it’s generally still too close to call. “They’re both good for you,” Hamilton says. “TFSAs are a bit simpler, but you could just pick one or the other.” High-income Canadians have the easiest choice, says Hamilton. “They have the luxury of using both.”

The 30-second TFSA

• The TFSA is a savings or investment account you can use to save for large purchases or retirement
• You don’t pay taxes on investment returns inside your TFSA
• You don’t pay taxes on money you take out of your TFSA
• You don’t get a tax refund for contributing to your TFSA
• You don’t have to worry about clawbacks when you withdraw from your TFSA
• You can contribute up to $5,000 a year
• If you contribute less than $5,000 in a given year, the unused room is carried forward
• If you take money out, you get that contribution room back
• Contribution room begins accumulating at age 18, even if you don’t have an account (as long as you file a tax return)
• Banks and brokerages will begin offering TFSAs in 2009