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.

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Ed Rempel

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.
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Dan
7 years ago

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!

Graham
7 years ago

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
7 years ago

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
7 years ago

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
7 years ago

@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
7 years ago

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?

k kofluk
9 years ago

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

Judie
10 years ago

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

FT
10 years ago
Reply to  Judie

@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.

David R.
12 years ago

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.

Ed Rempel
12 years ago

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://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