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Tax-Free Savings Account (TFSA) – How should we use it?

This is a guest post by CFP and CMA Ed Rempel on his opinion about how to appropriately use the Tax-Free Savings Account (TFSA).

The only reason I need these gloves is ’cause of my hands. – Yogi Berra

2009 brings one exciting new development – TFSAs. You may have seen a bunch of news coverage about them. We consider them to be the best new retirement savings vehicle since RRSPs. For many, perhaps most Canadians, they will be better than RRSPs.

What They Are and How We Should Be Using Them

First of all, it is pronounced “TiFSA”. The easiest way to explain them is that they are exactly like RRSPs except for 4 differences:

  1. The main difference is that you do not get a tax deduction for contributing and you do not pay tax on any withdrawals.
  2. Everyone 18 and over (no maximum) can contribute up to $5,000/year, regardless of income.
  3. Any amount you withdraw, you can recontribute the next year (or any time after that).
  4. There are no spousal TFSAs, but you can contribute to your spouse’s TFSA.

Other than these 4 differences, they are exactly like RRSPs.

How should we use them? There are 3 options:

  1. Use them like your RRSP and max both (Best use) – If you can afford to max both the TFSA and RRSP, you should do that and invest them both similarly for the long term. For us financial planners, this will provide lots of tax planning opportunities after you retire. We can effectively determine your tax bracket by how much we withdraw from each.
  2. Use either TFSA or RRSP for your retirement savings, depending on your situation (2nd best use) – If you cannot max both, then you need to determine which is best for you and use. If it is TFSA, then invest it like you invest your RRSP now with long term investments.
  3. Use the TFSA for short term savings/emergency fund (Last resort use) – If RRSPs are better for you and you cannot afford both, then using a TFSA for your savings account is a reasonable use. The long term tax savings should be many times higher if you invest in long term investments, even if they are tax-efficient.

How do you determine whether TFSA or RRSP is better for you?

The best way to figure it out is to compare your marginal tax rate now to what you think it will be when you withdraw, presumably after you retire. For example, if you are in a 40% tax bracket now and you expect to be in a 20% bracket after you retire, then RRSPs are better for you. You will get a $4,000 tax refund from a $10,000 contribution, but only have to pay $2,000 tax in retirement when you withdraw it.

The issue here is that there is a common misconception among Canadians that almost everyone will be in a lower tax bracket after they retire. The truth is that probably about half of Canadians will be in higher tax brackets after they retire. The reason for this is all the clawbacks on income for seniors.

In Canada, we like to provide income for seniors, but then take it away if they have other income. Therefore, seniors face clawbacks in addition to income tax:

  • 50% on the GIS (part of Old Age Security but for very low incomes)
  • 15% on the age credit
  • 15% on Old Age Security
  • 5% on GST income.

The end result is that the top tax bracket in Ontario for those under 65 is 46% on income over $121,000, but seniors that earn either under $22,000 or over $37,000 will be in even higher tax brackets between 43%-72%.

Can you believe they tax some low income seniors at 72%?

The short answer, then, is that if you expect your retirement income to be either very low (under $22,000) or moderate to high (over $37,000), then TFSAs are probably better for you than RRSPs.

The other big issue is what you use your tax refund for. If you spend your tax refund, then TFSAs will be better for you. However, if you have an important use for your tax refund, such as contributing it to an RESP for your children’s education, then the RRSP may be better. Contributing to a TFSA will not give you that tax refund.

Final Remarks

In most cases, a combination will be best. This will mean that you would retire with a large nest egg both in an RRSP and in a TFSA, which gives us great control in minimizing your taxes by deciding exactly how much to withdraw from your RRSP (or RRIF) and how much to withdraw tax-free from your TFSA.

Here are 2 more in-depth articles on TFSAs vs RRSPs:

Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.

If you would like to read more articles like this, you can sign up for my free newsletter service below (we will not spam you).

About the author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.

Ed has written numerous articles to educate the public and his clients on his unique insights into strategies that actually work, instead of the “conventional wisdom” common in the financial industry.

Ed has trained more than 200 financial advisors and is considered the Smith Manoeuvre expert in the Toronto area. He has received accolades from Frasier Smith in his book “The Smith Manoeuvre” for customizing this strategy for hundreds of clients. His extensive experience in tax and finance has placed him in high demand. Ed’s team collaborates on each of their clients to help them create financial security and freedom.

{ 33 comments… add one }
  • Adam February 3, 2009, 9:28 am

    Just wanted to say thanks for this article. It’s something I’ve been thinking about, as my wife and I are both under 30 and looking to really get our retirement funds going, but are also both employed by organizations that have a well structured fixed benefit pension plan.

    I’ve been thinking that given projected salary growth and the probable pension payments, that this might be the best channel for growth, and this article has helped confirm that.

    Thanks!

    Adam

  • DavidV February 3, 2009, 9:58 am

    I’m certainly not an accountant, but if you have a fixed benefit pension (and you assume it’s safe) I’d invest in the TFSA, since you’re going to be taxed on your pension benefits. I think, and as a non-pension holder I don’t actually know, that you get a tax benefit for pension deductions from your paycheque?

  • Kathryn February 3, 2009, 10:42 am

    Excellent article.

    You are right. It is a common misperception that people will be making less in retirement. I certainly plan on making more in my retirement years than I do now! That’s the whole point of MDJ, with steady saving, strong investments and the miracle of compound interest, I hope to be making a lot more.

    For our situation, we’re maxing out the TFSA first. I’d rather pay the tax now and let it grow tax free over the years. My only concern is how easy it is to access. For that reason, this year we’re transferring our emergency fund to TFSAs. We will continue to pay into our RRSP this year and beginning next year, our plan is to max out our TFSA every year first before we make any further contributions our RRSPs. If we need to access the emergency fund, it’s there. Otherwise, we’ll leave it alone until we can take it out when we need it without penalty or taxes during our retirement. Now that’s what I call freedom!

  • DAvid February 3, 2009, 11:12 am

    “First of all, it is pronounced “TiFSA””

    So do you mean TiF-Saw, or TiFS-eh? :-)

    Thanks for the clear explanation.

    DAvid

  • Four Pillars February 3, 2009, 11:17 am

    I have a few problems with this article:

    1) How do you figure that seniors that make over $37k will be paying 43-72% marginal tax rate? That’s just not true.

    2) The idea that the rrsp is only beneficial if your marginal rate in retirement is less than your current marginal rate is also not always true. When you make contributions the tax saving is at the marginal rate – when you withdraw – the tax is spread out over the entire years withdrawal.

    ie Let’s say I contribute $10,000 per year and save 40% tax on those contributions. Later on when I have enough saved (let’s assume no other savings, income etc) I’ll retire and will withdraw money each year – let’s say $60,000 per year. At that point my marginal rate might be 40% but my effective tax will be the amount of tax paid over the $60 which will be much less than the marginal rate.

    The fact is that it is possible to withdraw money in retirement at a higher marginal rate than when you are making contributions and still come out ahead.

    Obviously if you have a good pension then this scenario doesn’t fit.

    3) Who makes more money in retirement than when they are working? Unless you love your job and don’t want to retire then that is just bad planning.

    4) “TiFSA”? Nobody calls it that. :)

  • Garett February 3, 2009, 11:20 am

    Taxtips.ca has a handy calculator to determine which option or combination is best for your particular situation. Check http://www.taxtips.ca/calculator/tfsavsrrsp.htm for background info and a link to the calculator.

    NOTE: I am not associated with TaxTips in any way, other than my firm having a listing in their directory. However, I do use their site and various calculators from time to time and have really benefited from it.

  • Kathryn February 3, 2009, 11:53 am

    Garett ~ Interesting calculator. Thanks for posting it. For our situation it said that TFSAs are better than RRSPs, which is good because that’s what we plan on using. :-)

  • Victor February 3, 2009, 1:25 pm

    While I have no expectations of making more during retirement than during my career, I’m currently in the first 5 years of my career and thus hope to be making more in retirement than I do now.

    I can afford to max both my TFSA and my RRSP contributions, but lately I’ve been thinking that this may not be the wisest choice. I’m frugal and have the self-control to invest in non-registered funds and not withdraw the money.

    Any comments on whether it might be worth saving up the RRSP contribution room until I’m making significantly more than I am now?

  • Traciatim February 3, 2009, 1:56 pm

    I agree with FourPillars on the “Can you believe they tax some low income seniors at 72%?” point.

    If you were to make a comparison and include the loss of the GIS because you are being taken care of you would also have to include the loss of income tested benefits of rent subsidies and social assistance to a regular income earner making 40K a year.

    Lets look at a family of 4, with 1 child under 6. They make 40K a year and one spouse stays home with the kids. This in contrast with a family of 4 on social assistance in the apartment next door with their rent subsidized. The going rate for the apartments will be $700 per month.

    Family 1, 40K income. On this income they will pay:
    8400 Rent
    5470 Income Tax
    1807 CPP
    692 EI

    They will also receive:
    2529.36 CCTB
    1200 UUCB

    So, 40000 – 8400 – 5470 – 1807 – 692 + 2529.36 + 1200 = 27360.36 to live.

    The social assistance at $1000 a month will pay (Extended rate in NB, 4 person):
    8400 Rent

    and they will also receive:
    4800 in rent subsidies (to make rent 30% of income)
    7180.92 CCTB
    1200 UUCB

    So 12000 – 8400 + 4800 + 7180.92 + 1200 = 16780.92 to live.

    The difference being that the 40K person was giving up the 4800 in rent subsidies, 4651 in CCTB, plus pays 7969 in taxes and fees that they would not had they not gone to school to get a good job. That totals 43.55% they pay in “tax” just to work. Oh, and I almost forgot the 12000 that they would have received for social assistance income, making their new “Tax” rate 73.55%. So essentially nothing changes in retirement. The people who don’t plan ahead get rewarded and the people who do get punished.

  • Traciatim February 3, 2009, 2:01 pm

    You also forgot to mention option 4 for the TFSA, use it to split income with a non-working spouse.

  • Ramis February 3, 2009, 3:38 pm

    good article……here are couple of other methods to use it. If you are in lower tax bracket and expect to be in a higher in the future, instead of making contributions to your RRSP you could contribute to TFSA instead enjoy the tax free growth and then top up on ur RRSP and get the higher tax return.

    Also one of the ways I am planning on using TFSA is to use it in retirement for lumpsum purchases and use RRIF as income. Since TFSA is not taxed it would be much more efficient to use it for one time expenses like trip, car purchase etc….

    just some ideas

  • Tanya February 3, 2009, 4:27 pm

    I am using the TFSA to save now while I am in a lower tax bracket. =)
    I like that it is MY money….the government has no way of putting their sticky fingers on it now or when I retire. Tax-free may not make you the big bucks, but it is YOUR bucks. Your life time of working and savings guaranteed to you with no surprises. What could be better than that?

  • chris February 3, 2009, 5:14 pm

    ive heard the term TIS-FA thrown around a few times. less of a mouthful than T-F-S-A

  • Mark February 3, 2009, 8:51 pm

    Good article.

    I totally agree with option # 1 – try to max out both RRSP and TFSA.
    Easy to say, hard to do. Certainly, if your income is > $50 K, there’s benefits in having an RRSP.

    Back to the TFSA – did anyone open one via a discount brokerage account?
    If so, what investments are you holding in there?

    I’m thinking about holding some not so risky, but steady bond funds, bond index funds, or some other income producing investments.

    Although there’s merit in having your $5 K in a PCF TFSA earning ~ 3.75%, I want to make more than that…

    I would be interested in learning if any folks have opened a discount brokerage TFSA.

    Keep the good posts coming,
    Mark

  • Ramis February 3, 2009, 10:47 pm

    I have one with E-trade canada………currently not holding really anything but the plan is to hold either a zero coupon bond or a good US dividend paying stock (since u dnt get the dividend treatment)……i dnt want to hold put tfsa money in mutual funds most likely it will be bonds specially right now take advantage of the great spreads.

  • Sampson February 4, 2009, 2:44 am

    @ Mark

    My wife and I each have TFSA accounts at RBC Direct Investing. I’ve started doing in-kind transfers of my existing income trusts I had been holding in a normal non-registered account. My plan is to pack high yielding income trusts, and US dividend paying stocks.

    For my wife, her account will be built around ETFs, so since the bonds are already in her RRSP, we’ll put the higher yielding US and international ETFs in there.

  • Ray February 4, 2009, 4:15 am

    I have my TFSA at TDW and have $2500 in PD.UN yielding 9.5% income and AVF.UN yielding 20.6% income for now. Not sure what I’ll pick next year, we’ll see.

  • Maria February 5, 2009, 1:47 am

    Thanks for the helpful insight. I’ve been looking into TFSAs for a few weeks now and I still haven’t figured out if it’s right for me or not.

    I’m a full time university student so I fall under the lower tax bracket. With that in mind (and the fact that I’m still new to investing), does this affect how the CRA tallies my OSAP? I’m thinking contributing my OSAP loans into the TFSAs and pay it back afterwords. Is this logical?

    thanks!

  • DK February 5, 2009, 10:51 am

    RRSPs are great except when they grow too large because when you turn 71 you have start withdrawing roughly 7-8% of the total value each year, potentially placing you in high tax brackets in retirement.

  • Remus February 5, 2009, 2:02 pm

    I’ll throw in my 2 cents here as well…
    So from what is happening around the world now and from what I have been reading and reading and reading there is a chance of high inflation (some might go as far as calling a hyperinflation trend) if all this liquidity put in the banking system by central banks starts to make its way to the end user. So far it hasn’t as the banks just hoarded the cash but the latest trend I see from governments is to start stepping into banks business (maybe one day by fully nationalizing them) and try somehow to force them into lending out more money. I see provisions of TARP money linked with clauses like that: you only get money if you lend them out…
    Personally I have a very low level of esteem for the ability of the FED to solve a lot of these problems (or of the rest of the central banks for that reason) so I will play a moderate card and tell myself: the risk of inflation in the years to come is worth considering.
    Considering that gold is a good hedge against that (as are commodities too from what I’ve read but with the world in recession for some time I think there will be a good few years until they pick up again in price) personally I think having some exposure to that is a must have. Maybe play the gold hand for a while and later switch to commodities.
    I know Questrade has been bashed really bad in users comments but their option of Gold in RSP sounds very tempting. I don’t know if they offer a GOLD in TFSA too but it’s worth looking into it.

  • Mark February 5, 2009, 8:25 pm

    Thanks everyone.

    @ Sampson: I think I will start my TD Brokerage TFSA with probably an EFT (XIU).

    @ Ray: AVF.UN got 20%?

    Mark

  • Ray February 5, 2009, 9:46 pm

    23.1628% today. XIU is a great idea too, running 3.5% with potential for a ton of cap gain too.

  • Ed Rempel February 6, 2009, 10:15 pm

    HI Kathryn and Four Pillars,

    The common misconception for Canadians is that they will be in a lower tax bracket in retirement, not that they will have lower income. You can have a much lower income in retirement, but still be in a higher marginal tax bracket.

    This is because of all the clawbacks that affect all seniors. The details are in an article: https://www.milliondollarjourney.com/tfsa-vs-rrsp-clawbacks-income-tax-on-seniors.htm .

    Unlike rent subsidies and social assistance, the clawbacks do affect all seniors. They may not technically all be “tax”, but they are cash from the government that anyone can get.

    Your marginal tax rate after you retire is critical to figuring out TFSAs and take some projections to figure out. On top of whatever other retirement income you will have, RRIF withdrawals would be taxed at the marginal rate each year, while TFSA withdrawals will be tax free.

    TiFS-eh would be a truly Canadian pronounciation. Perhaps it’s better than TiFS-uh. :)

    Ed

  • David R. February 24, 2009, 2:12 am

    Victor wrote:

    Victor if you can afford to maximize both, do so, and don’t “save up” contribution room in your RSP. You’ll get the tax refund now, your investments will grow tax free, and you can invest the tax refund as well, preferably in a non-registered account (because you’ve already maxed out your registered ones).

    Don’t aspire to join the legions of Canadians with loads of contribution room in their RSPs.

  • Judie December 1, 2010, 6:23 pm

    Withdrawal from RRSP every year prior to a RIF to deposit into a TFSA! Is this a tax advantage when on a low pension?
    JR

    • FrugalTrader December 1, 2010, 6:33 pm

      @Judie, RRSP and RIF withdrawals are both taxed as income. From what I can see, depositing either a RIF or RSP withdrawal into a TFSA would result in the same tax consequence. One thing to consider though is if your first RRIF withdrawal will push you into a high tax bracket, or result in OAS clawback. Then it may be a good idea to slowly reduce your RRSP balance before RRIF starts.

  • k kofluk April 17, 2011, 12:44 am

    This may not be for everyone, but if the TFSA is considered as only one small part of each persons overall investing strategy(s), I see no reason why the following can not be considered as the aggressive 10% of persons overall plan… here is a Blog I wrote with my aggressive stance to eventually eliminate the need/reliance on SDRRSP accounts and cash accounts…http://www.stockhouse.com/Blogs/ViewDetailedPost.aspx?p=99025&msg=11

    To me this should become the focal point for all investors in Canada…paying no taxes on investments, a dream come true,strive everyone…

    GLTA investors…great site:o))))

    Magnum

  • Graham September 12, 2013, 9:27 pm

    Using TFSA to buy a new car.

    We need a new car.
    We have about $60k in our two TFSAs and will have about $71k by January.
    The new car will cost, say, $50k incl tax after trade which will be the down payment.

    We have a few options:
    – Pay cash for car out of TFSA
    – Finance the purchase using TFSA withdrawals for payments.

    The financing that is available, is at an interest rate of 1.9%. These options are available to us:

    1. Finance entire amount over 60 months.
    2. Draw say $20k from TFSA as a deposit and finance remainder over 60months (top TFSA up in January)
    3. Finance over 48 months, with $20k balloon payment at end.

    Calculators says:
    1. $874/mo Total interest $2492
    2. $525/mo Total interest $1471
    3. $681/mo. Total interest $2698

    Anyone else done this? Comments?

    We would use high yield equity funds in TFSA such as SIN.UN (yielding over 8%) and one or two others. FIE is a possibility. Any other suggestions?

  • Dan September 13, 2013, 4:35 pm

    @Doug – best option is to likely finance it all since the rate is so low and your rate of return is much higher. As long as you can keep earning 8% in your TFSA you are better off to finance the entire thing at a much lower rate (1.9%). You could keep topping up your TFSA and use the earnings to pay for the car. Just a thought. I havent run the numbers but I’m pretty sure your tax-free return would beat the interest costs paid, assuming of course your cash flows can handle an extra pmt of $875/month

    Just out of curiousity what kind of vehicle?

  • Graham September 13, 2013, 10:56 pm

    Dan,
    You are right, that from a strictly financial view, financing the whole amount at 1.9% probably makes sense.

    Being retired, we currently have just sufficient cash flow from our taxable accounts and government pensions to cover our living expenses. We are now both drawing from RRIFs. We would like to use whatever is left after taxes to top up the TFSAs and add to our taxable accounts.

    We would like to strictly use the TFSAs to finance the new car. Perhaps it would be best if the payments are not too much higher than what we can earn on our TFSA balance? Otherwise the capital will be eroded during the year because we will have to sell off some of our holdings to supplement the earnings. Downturn in markets could make that worse.

    I am tending toward a version of option 2., but am interested in what others think.

  • Dan September 14, 2013, 12:32 pm

    We are in a similar situation in that we will need a new car in the next 1-2 years and could use the cash we have in our TFSAs to fund it. I have a hard time taking cash out of our TFSA because it currently earns about 7% thru dividends. But you’re right – getting the pmts down to equal the earnings in the TFSA would be ideal for cash flows and that’s probably what we will do as well. It’s definitely not ideal to have to sell from other accounts as a downturn could mean losses as you mentioned

    $50k – must be a nice vehicle :)

  • Graham September 14, 2013, 1:56 pm

    We don’t at present earn 7% in TFSA, but would like to! I am in process of re-arranging our TFSA holdings. One I have used for years, is SIN.UN. But still looking for others to add. I don’t want too many holdings because we will have to sell from time to time to provide enough for payments. So perhaps SIN and two other diversified funds rather than individual stocks. How do you earn 7% in dividends?

    Re $50k car. Almost any mid sized car we looked at came close to that by the time a few extras, delivery and taxes were added. We are getting a Mercedes GLK250 diesel. MSRP $43,500. Our second choice was a Subaru Outback, but for top of line it was about $40k before taxes etc. Warranty and fuel consumption not as good as GLK.

  • Dan September 15, 2013, 1:53 am

    We don’t have much in our TFSAs at the moment but everything we do have pays dividends. We sell when they get relatively high and buy more when they’re low. We are into RSI.TO, COS.TO, BMO.TO and CPG.TO. We try to look for companies that are able to keep up their div pmts in the event of a downturn. We always reinvest the dividends. Haven’t looked at SIN but will look into it. When we do have to buy a vehicle I’m hoping we can use the div income from the TFSAs to help with the car pmts. Rates are too low for us to pay cash so little incentive. One drawback is that the TFSA is partly an emergency fund so if anything came up that plan wouldn’t work. I suppose it depends on personal risk tolerance.

    Good choice on the Mercedes!

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