Personal Finance

Now that tax-free savings accounts are available, RRSPs are no longer the only way to go for tax savings.
By Gail Bebee | 08/01/10

The year-old tax-free savings account (TFSA) is the best new federal government program to be rolled out in years. In fact, it's such a boon to long-suffering Canadian taxpayers that I believe an era has ended. The traditional January-February registered retirement savings plan (RRSP) season is obsolete. It's been replaced by "tax-free retirement savings" season. That's TFRS for short (since every financial concept needs a good sound-bite acronym). Never heard of TFRS? Let me explain.

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TFRS is simply a combination of TFSA and RRSP. The TFRS season is the time to make your annual contributions to these two federal savings plans. In the old RRSP era, it was an RRSP contribution or nothing. In today's TFRS era, things are a bit more complicated. You need to decide whether to contribute to one or both plans, or not contribute at all.

A TFSA is a tax avoidance plan. All adult Canadian residents can contribute $5,000 (after-tax dollars) annually to this type of registered account and pay no tax on the profits earned. It is a flexible plan: tax-free withdrawals are available at any time and the withdrawn amount can be re-contributed the following year. As well, unused contribution room carries forward to future years.

By contrast, an RRSP is a tax-deferral plan, in which investments can grow tax-free. Canadian taxpayers can contribute untaxed dollars, up to 18% of their previous year's earned income. The maximum RRSP contribution for the 2009 tax year is $21,000, and for 2010 it's $22,000.

An RRSP is less flexible than a TFSA. When the money is withdrawn, it is fully taxed and cannot be re-contributed unless you have contribution room. Moreover, once you turn 71 years of age, you can no longer contribute to an RRSP. As with a TFSA, unused RRSP contribution room carries forward to future tax years.

While you can contribute to a TFSA throughout the year, you should do so in January in order to maximize tax-free investment growth. Similarly, to maximize tax-deferred investment growth, make your RRSP contribution in January of the year you claim the RRSP contribution on your income tax return.

Investments that qualify for a TFSA are similar to those eligible for an RRSP and include everything from cash, GICs and bonds, to stocks, mutual funds, exchange-traded funds and more. In-kind transfers of non-registered investments are allowed. Note, however, that such a transfer could result in reportable capital gains.

Inside TFSAs and RRSPs, you lose the benefit of the lower tax rates for capital gains and eligible Canadian dividends, and capital losses cannot be deducted from capital gains. Given these tax considerations, both types of registered plans are suitable for holding highly taxed investments such as GICs, bonds, real estate investment trusts (REITs) with fully taxable distributions, and foreign blue-chip stocks that pay dividends.

As a general rule, those who are able to contribute to both a TFSA and an RRSP should do so to maximize their tax benefits. If your funds are limited, consider making an RRSP contribution and putting the resulting tax refund in a TFSA.

Another option for those on a tight budget is to use a TFSA as an emergency fund. If you expect your present and future tax rates to be similar, or plan to withdraw the money when you'll be in a higher tax bracket, the TFSA is your first choice because it is more flexible. For example, it could be used by young people saving to buy a house because their income-tax bracket is likely to be higher when they withdraw the money to purchase a home.

A key feature of the TFSA is that neither income earned within the plan nor any withdrawals will affect eligibility for income-tested government benefits and credits. This makes the TFSA the preferred choice if your RRSP, on conversion to a registered retirement income fund (RRIF), would generate sufficient mandatory distributions to trigger a clawback of your government Old Age Security (OAS) benefit.

A TFSA trumps an RRSP contribution for people close to retirement who have little or no savings or pensions, because TFSA withdrawals do not affect eligibility for the Guaranteed Income Supplement (GIS) for low-income seniors. You can find out more about income limits affecting OAS and GIS benefits at the Service Canada web site.

An RRSP contribution ranks above putting money in a TFSA if your current income tax rate is higher than the rate you expect to pay when you withdraw the money. This is the case for many Canadians who are saving for retirement. An RRSP will also be the preferred destination for your savings if you plan to borrow money from your RRSP to buy your first home using the government's Home Buyer's Plan or to further your education under the Lifelong Learning Plan.

TFRS season is an opportune time to get your personal finances in order. Why not devote a few hours this month to reviewing and updating your household budget and personal financial plans for 2010? As part of your planning, do consider TFSA and RRSP contributions. Both savings plans offer you the dual satisfaction of paying less tax and achieving your personal goals sooner.

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