The tax-free savings account (TFSA) turned 10 this year — and it has come a long way.
More than 40 per cent of Canadian families now have one, according to the latest tally from Statistics Canada. And while that’s still less than the nearly 60 per cent who have a registered retirement savings plan (RRSP), it’s an impressive uptake considering TFSAs have only been a thing since 2009, while RRSPs date back to 1957.
Still, many Canadians who have TFSAs are choosing to keep things simple, using them largely as savings accounts. A whopping 42 per cent of TFSA holders have a significant amount of money in their accounts sitting in cash, according to a newly released poll conducted by Ipsos for RBC.
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But is that a good idea?
There are pluses and minuses.
The obvious drawback to using a TFSA simply as savings storage is that you’re not making the most of tax-free compounding.
“The magic happens when you invest the money within your TFSA and gain the benefit of compounding, which helps your earnings generate even more earnings,” Stuart Gray, director of RBC’s Financial Planning Centre of Expertise, said in a statement.
A TFSA, like an RRSP, is a personal account that shelters your savings from tax. The idea is that if you invest your money and earn a return, you have the ability to keep reinvesting all of your return in addition to the sum with which you started. In a simple savings account or a non-registered investment account, by contrast, you’d have to hand over part of the interest you earn or a share of your investment gains to the government as tax. Inside a TFSA or RRSP, though, tax-free compounding is a powerful tool to turbocharge your savings.
The problem with using a TFSA like a high-interest savings account is that the interest they earn is small — and so are the benefits from compounding. You could see your money grow considerably faster if you put your cash in investments with better returns.
“The true advantage of contributing money to your TFSA is to help you reach your goals, not just to have a short-term savings account,” Gray said.
But the other key feature of the TFSA is that it lets you take money out without any tax consequences. As most people know by now, that’s the big difference between a TFSA and an RRSP.
With an RRSP, you get to contribute with pre-tax dollars, which means there’s more money available for you to take advantage of tax-free compounding. The catch, though, is that you’ll have to pay taxes when you take the money out.
With a TFSA, on the other hand, Canadians contribute after-tax dollars. No tax is due upon withdrawal because they’ve already paid their due.
The reason why many treat their TFSA as a savings account is the ability to take money out without cost or hassle, said Rona Birenbaum, a certified financial planner and CEO of Caring for Clients.
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When keeping your TFSA in cash makes sense
According to the Ipsos poll, 25 per cent of respondents are using their TFSAs for everyday savings, 10 per cent to save up to buy a home and 35 per cent for an emergency fund.
If you’re saving up for a short-term goal, a tax-free, high-interest savings account is probably where your money “should be,” said Birenbaum.
While a diversified portfolio of stocks and bonds can be a good way to reach your goals faster, if your target is less than five years away, a high-interest account can also be a good option, said Jason Heath, managing director at Objective Financial Partners.
Another option for growing your short-term savings is to use Guaranteed Investment Certificates (GICs), which generally pay a fixed interest rate for a set term like three months, a year or five years. GICs with a term of up to five years also guarantee your principal, up to set limits.
Still, high-interest savings accounts these days often pay higher interest rates than GICs without the need to tie up your money for a set amount of time, Heath said.
TFSAs for retirement
TFSAs can also work well for retirement savings, which is what 38 per cent of Canadians are doing with them, according to the Ipsos poll.
There’s a strong case for low-income Canadians to use TFSAs as their retirement savings vehicle of choice. That’s because, unlike money coming out of an RRSP, TFSA withdrawals do not count as taxable income that could trigger a clawback in benefits such as the Guaranteed Income Supplement (GIS).
Saving in a TFSA also makes sense when someone is in a lower tax bracket than they expect to be later in their working life. A popular move is for young people to start saving in a TFSA and move the money over into an RRSP when their income grows and they’ve moved into a higher tax bracket, which allows them to make the most of the RRSP tax break on contributions, Birenbaum said.
The issue with using TFSAs for retirement, however, is the ease of withdrawal, which can be a temptation to dip into what should be off-limits money, Birenbaum added.
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TFSAs in retirement
While Canadians are evenly split over whether they prefer to save in a TFSA or RRSP, those aged 55 and up show a strong preference for TFSAs, the Ipsos poll shows.
Richard Shillington, an Ottawa-based statistician and public policy analyst, isn’t surprised. Low-income seniors who have been saving up in an RRSP are often better off gradually emptying that account in the years leading up to retirement and moving the money over to a TFSA, he argues. For seniors who receive the GIS, the tax hit from emptying the RRSP before retirement will usually be smaller than the gain from avoiding a reduction in government benefits during retirement, Shillington noted in a report published earlier this year.
For older Canadians who have lots of contribution room, TFSAs make for a good receptacle for “windfall money” like an inheritance or the proceeds from downsizing their home, Shillington said.
And for well-heeled seniors, TFSAs can also be a “powerful wealth-building tool,” Birenbaum said.
For higher-income clients who want to leave assets behind, Birenbaum advises withdrawing enough from their RRSPs or registered retirement income funds (RRIFs) to maximize their yearly TFSA contributions, in addition to covering living expenses.
The issue is that the value of an RRSP/RRIF when you die is generally included on your final tax return, which can lead to a hefty tax hit for your family. (One important exception is that a surviving spouse designated as the beneficiary can roll over your RRSP/RRIF amount into their own RRSP/RRIF without any tax consequences.)
With a TFSA, by contrast, your designated beneficiaries would only have to pay tax on any income earned by your investments after the time of your death. The rest can be paid out tax-free.
Ipsos conducted the poll between Nov. 20 and Nov. 26, 2018, on behalf of RBC Financial Planning through a national survey of 2,000 Canadians aged 18 and over who completed their surveys online. The poll is accurate to within ±2.2 percentage points, had all Canadian adults been polled.