The Canadian government announced the creation a new savings account type (Tax-Free Savings Account) which allows Canadians to contribute after-tax money without any taxes on the earnings within the account (interest, dividends, capital gains) and there will be no withdrawal taxes whatsoever. For any Americans reading, this account will be very similar to your Roth IRA account except there aren’t any restrictions on withdrawals in the TFSA.
While this announcement has generated a lot of excitement in the Canadian blogosphere and for good reason, since it will be very useful financial planning tool, my opinion is that the benefits of this new savings account will be very limited for the average Canadian.
Here is an explanation of the new tax free savings accounts for Canadians.
First of all let’s look at some benefits and uses for this new account.
Saving for large purchases during your working years
In my mind, this is one of the greatest benefits of this new account. If you are saving up for a car, a house down payment, vacations or anything else, this account is the way to do it. Previously, if you wanted to save large amounts of cash then you had to pay your marginal rate on any interest earned which for most people is probably at least 30%. You could mitigate this problem with Canadian dividend stocks which are more lightly taxed, but they are still taxable and then you expose yourself to market risk since the money might not all be there when you need it.
I wrote recently about how I think having a cash emergency fund is not a good idea for someone with a mortgage, a HELOC and a high marginal tax rate. With this new tax sheltered account, my main argument about paying high taxes on the interest is now a moot point so the remaining issue is the interest rate you can get on the savings account vs. the interest you are paying on the mortgage. Unless you have a huge emergency fund, this small interest rate difference might not be large enough to sway the argument one way or the other.
A lot of Canadians don’t really understand the benefits of an RRSP account (American translation = 401k) which is unfortunate since it is the best tax planning and retirement tool available to Canadians by far.
TFSA are not as good as RRSPs for retirement planning because RRSPs allow you to defer all the tax payable on the contribution and to pay LESS tax upon withdrawal.
One of the common misconceptions of RRSPs is that you have to be in a lower marginal tax bracket in retirement than when you made the contribution. This is not the case because when you make a contribution, the tax deferral is the marginal tax on the entire contribution ie if you make $100k and contribute $10k of pre-tax income and your marginal rate is 43% then you are deferring $4300 of taxes.
When you withdraw this money in retirement then you are paying the AVERAGE tax rate on the withdrawal – not the marginal rate (assuming no other income). So if someone withdraws from their RRSP in retirement and is at the same marginal tax rate as they were when they made the contribution, they will still save a lot of tax. In reality they will probably be in a lower marginal tax bracket which means they save even more tax.
With the TFSA, you don’t get this benefit since you pay your marginal tax as soon as it is earned.
For investors who have money in non-registered accounts either because they have already maxed out their RRSPs or other reasons, this new account is a huge benefit since they can reduce the tax drag on earnings on their investments. Previously dividends and capital gains (if they occurred) had to be paid which affects the long term returns of those investments.
Why the general public won’t benefit
Saving for purchases – I don’t believe very many Canadians save for large purchases. You don’t need 20% to buy a house and things like cars and vacations are so easily bought on credit that most people won’t bother to save. Even if we are savers, most of us don’t appreciate the effects of tax drag so paying taxes on the interests may not bother everyone (like it bothers me!).
Emergency fund – Similar to my previous point, how many Canadians even have an emergency fund? While our high taxes made an emergency fund fairly inefficient, with the TFSA this is not an issue anymore. I doubt it will make any difference for the average Canadian since I don’t think they will consider having an emergency fund.
Retirement Savings – The reality is that there are a lot of Canadians who don’t save enough (or at all) for their retirement so introducing a new method (which isn’t even designed for retirement savings) isn’t going to help them. Since I believe that a lack of understanding of how RRSPs work might discourage some Canadians from using them, I am hopeful maybe some of those people will use a TFSA instead since it’s a lot better than nothing but I doubt that many of them will.
Who will benefit?
Simple – savers. People who save, people who complain because they don’t have enough RRSP room, people who invest outside their RRSP, people who are doing a Derek Foster plan (retire on dividends), geeky personal finance bloggers (I guess I could have omitted the word geeky) 🙂