I like the tax-free savings account: It’s about time

February 29 2008 by Ellen Roseman

The tax-free savings account unveiled in the budget this week is a wonderful gift for savers, a much-needed option for those already saving money in a tax-sheltered RRSP. Now you can hedge your bets and not have to worry about high taxable withdrawals in retirement.

About five years ago, I started writing columns about how RRSPs weren’t suitable for people living at a subsistence level. They might have put away money when they were young, thinking this would help them in later life, only to find that their RRSP income pushed them into a higher tax bracket and robbed them of some mean-tested benefits.

My thinking was informed by Richard Shillington, an Ottawa-based policy wonk who spent some time as a resident academic at St. Christopher House in Toronto. He talked to older clients of the social agency and found many weren’t getting the government benefits, such as the guaranteed income supplement, they were entitled to because they didn’t know about them. He also noticed the destructive impact of their RRSP savings.

He wrote a couple of papers for the C.D. Howe Institute, calling RRSPs a fraud on the poor — strong language for the venerable think tank. He urged Ottawa to tackle the perversity of the current system’s administrative rules, setting up something like the Roth IRA in the United States. If not, the financial services industry should run an educational campaign telling low-income Canadians not to buy RRSPs.

Only slowly and with difficulty is the word seeping out that that RRSPs are a poor savings vehicle for the GIS-destined. That RRSPs are a poor investment vehicle runs contrary to the monolithic financial advice that they are good for everyone. The small voice warning low-income Canadians must fight the advertising onslaught each January and February in RRSP-selling season.

The previous Liberal government warmed to the tax-free savings account. But despite encouraging words in each budget, they never did anything but study it. Much as I dislike Stephen Harper and Jim Flaherty, I have to admire their willingness to shake up the tax system in Canada and allow another option for savers.

The thing about life is that it’s so unpredictable. You never know where you’ll end up. You’re riding high today and then you you lose your job, get sick, have an accident or find yourself being an unpaid caregiver for a family member. Suddenly you’re going to food banks and lining up at the welfare office. You need financial resilience to bounce back from adversity.

Despite all the scary statistics about debt levels, many Canadians do put away money for the future. But their savings efforts should be rewarded, not punished by taxes and clawbacks that confiscate much of what they have set aside.

I often talk to middle-class people who regret their decision to save in RRSPs. They didn’t realize the taxes would be so high and the withdrawal rates so inflexible. Now they have a savings vehicle that won’t give them a tax deduction on the way in, but won’t penalize them on the way out. It never hurts to have more choices.

The Roth IRA is a popular feature of the U.S. tax and savings regime because it’s so useful, especially for young people. If you put pretax money into a savings plan at age 20 and leave it in until age 71 when you have to begin withdrawals, “you have been growing taxes for Uncle Sam for 50 years,” says a proponent.

So, let’s enjoy our $5,000 of tax-free savings in 2009 and wait for successive governments to increase the limits, as I’m sure they will (just as they did for RRSPs). This is one budget gift that will keep on giving.

11 comments

  1. bylo

    Mar 1 2008

    Not to look a gift horse too closely in the mouth, but what happened to “A Conservative government will… Eliminate the capital gains tax for individuals on the sale of assets when the proceeds are reinvested within six months”? 😉

  2. brad

    Mar 1 2008

    In terms of its ability to serve as an emergency fund as well as a retirement account, the TFSA is actually more flexible and a better deal than the Roth IRA. With a Roth, you are allowed to withdraw all your contributions at any time without penalty, but your earnings cannot be withdrawn until you retire (except for first-time homebuyers, who can withdraw up to $10K of earnings without penalty). As far as I can tell, there’s no such restriction with the TFSA.

  3. Wade

    Mar 2 2008

    I agree that it makes sense to have more choices. However, someone said that this plan is like a kiss from your sister – which I also agree with.

    It’s great for those that can afford to put away $5,000 a year.

    I think it benefits, for the most part, people who already have money and have maxed out their RRSPs. Maybe it’s me but I don’t know that many people with excess cash to sock away anywhere near $5,000 a year. I read somewhere that the average Canadian owes $116 for every $100 they earn. In the Globe yesterday or today, they had an article about how Canadians are awash in debt.

    Like the people Ellen mentioned, I’m not a big fan of RRSPs either, as you get socked with taxes when you really need the money (as you probably won’t have another source of income then). I would personally rather pay taxes now, while I’m still earning, and know that money I’ve socked away for retirement will all be available to me.

    That being said, because you can only make RRSP contributions on “earned income”, at least this TFSA would be of benefit to those people whose income is based on investment income and therefore they’re not able to make much in the way of RRSP contributions. Again though, we’re talking about people who aren’t in debt and already have money.

    I find it ironic that the same government that reneged on their promise not to tax income trusts, for fear of tax “leakage”, after encouraging people to take advantage of them, has now come up with something else that they want people to take advantage of.

    Would not simply raising the personal exemption by several thousand dollars benefit more people across the board, and especially those that need the break?

  4. bylo

    Mar 2 2008

    I don’t know that many people with excess cash to sock away anywhere near 5,000 a year and are in fact, living in debt.

    By Jove, I think you’ve got it! That makes it easy for the feds to introduce without risking the loss of much tax revenue. (You didn’t think they introduce this stuff for your benefit? ;))

    you get socked with taxes on it when you really need the money (as you probably won’t have another source of income then)

    You can’t get socked with taxes when you take money out in retirement if the RRSP is your only source of income (unless you have a humongous RRSP/RRIF.) The idea is you put money in during your earnings years, when you are at a high marginal tax rate, and then take the money out in retirement, paying taxes at a much lower rate. Meanwhile the money grows tax free. What’s not to like?

  5. Andy

    Mar 2 2008

    My wife and I have a joint investment account.

    If we wanted to transfer some of this to a tax free savings account, would we have to liquidate the asset(s) and pay any capital gains? Would we be limited to $5,000 or could we go to $10,000 on a joint basis? Or would we be forced to have individual accounts?

    Just wondering …

  6. brad

    Mar 3 2008

    Wade wrote It’s great for those that can afford to put away 5,000 a year.

    It’s also great for those who can only afford to put away $100 a year. There’s nothing that says you have to contribute $5,000 a year. You can contribute up to $5,000 a year.

    When I met my girlfriend, she was so poor she couldn’t even afford a toaster (she toasted her bread in the morning by holding it over the stove), but she still put a few hundred bucks into her RRSP every year. Most people could probably find the resources to do the same with a TFSA.

  7. bylo

    Mar 3 2008

    The TFSA is a nice complement to a high-interest savings account that you use for emergencies or to save for a “big ticket” item. Normally if you get, say 3.5% interest, by the time you factor in inflation and pay income tax on the interest, you’re lucky if you can maintain purchasing power. With a TFSA the interest grows and compounds tax-free, even after inflation. An RRSP is not suitable for this purpose because when you need the money you have to pay tax on it and you lose the contribution room permanently.

  8. Richard Shillington

    Mar 4 2008

    I don’t think they’re doing this primarily for seniors. Also, what they’ve done isn’t what I would have done.

    I’ve been pushing for some form of relief for the millions of Canadians who retire without an occupational pension and end up with a median income of about $15,000.

    If this weren’t bad enough, the design of GIS makes it near impossible for them to improve on this by earnings or by RRSP withdrawal – even their CPP was subject to a 50% clawback on top of which the income is still taxable (many won’t pay income tax but some will).

    Put this person in social housing where their rent is 30% of income and their “Effective Marginal Tax Rate” is now 100%.

    About half of Canadians retire with no occupational pension. The majority of those who retire without an occupational pension are eligible for GIS. About 80% of RRSP assets are held by those with an occupational pension.

    I recall that about half of those who retire with no occupational pension have some RRSP – the average amount is $30,000 to $40,000. Given their modest incomes, many people sacrificed in order to accumulate this small RRSP.

    Many low and modest income Canadians do save; they just don’t save much. Yet the GIS rules ensure that any RRSP savings do them virtually no good. Indeed, because of GIS clawback, CPP for many lower-income Canadians is not such a hot investment; it becomes a mutual fund with a 50% back-end load.

    ===============================================

    Remedies.

    1) My preferred option is to expand the GIS earnings exclusion to other forms of income. GIS should ignore about $4,000 to $5,000 of earnings but also other income – like CPP and RRSP withdrawals. This allows all Canadians to save in an RRSP without their having to guess whether they are “GIS destined” or not. Lower-income Canadians will not save much and will know that, at retirement, if they just keep their RRSP withdrawals below some modest amount ($3,50), it will not affect their GIS. This would also make CPP a much better deal for them.

    The $3,500 earnings exemption in the budget is a great step but doesn’t go far enough to be a remedy because it is only for earnings.

    This remedy would have been much cheaper to the government than the TFSA.

    2) This TFSA with the annual $5,000 of room helps my “futile savers” but has its problems. First, Canadians without an occupational pension will still have to decide if they should use an RRSP or TFSA. The banks and insititutions don’t sell good advice. They sell mutual funds. The TFSAs don’t simplify retirement planning for those without a pension plan. We will need to develop financial advice tools for lower-income Canadians to help them navigate the RRSP/TFSA decision.

    I also think that, in the long run, the TFSAs are HUGE for a few very high income Canadians. The accumulating $5,000 annual contribution limits are indexed (albeit awkwardly). At age 48 you have a limit, in constant dollars, of $150,000 per person in a couple.

    I would modify the TFSA to limit the lifetime contributions to a more modest amount, say $50,000. This will help my futile savers while limiting the windfall to the wealthy.

    Remember that in the short term, these TFSAs are not a windfall for the wealthy and will help many low and modest income Canadians. The unacceptable windfall only happens over the long term. We have 10 years during which one could create a lifetime limit that is acceptable.

    ======================

    Bottom Line…

    The TFSA is a remedy for my ‘futile savers’ but not my first choice.

    As proposed, it’s better than the status quo (some will disagree, we’re weighting trade-offs). But in the long run, it is very generous to a few higher income Canadians but we can fix that later.

    So… one could advocate for a broader GIS exemption instead. (Good luck on this, this TFSA is out of the bag and will be popular.) I would suggest advocating for limits to the ‘open ended nature’ of the TFSA, keeping its value for modest and lower income Canadians – many of whom do save in small amounts – but impose a lifetime limit, say $50,000.

    I agree with a suggestion I’ve heard that this would be a great opportunity to advocate for a $5,000 reduction in RRSP limits.

  9. Will Ashworth

    Apr 13 2008

    Why not replace the RRSP with the TFSA? Instead of giving rich people deductions of $18,500 a year (they’re the only one’s who can max out their RRSPs), allow anyone to deposit $10,000 a year into a TFSA. It seems to me this would be useful to more people.

    Of course, you’d also need to come up with something to satisfy the wealthy, who’d be losing their large deductions. Perhaps, the first $10,000 in interest on a mortgage could be tax-deductible.

    As a few people remarked, the TFSA allows you to build a good emergency fund/savings vehicle, something many of us don’t currently own.

  10. kelly

    Apr 24 2009

    Give me a break!!!People wake up and stop spending.I am from a middle income family.I save 12000 a year in rrsps and have maxed out our tax free saving account.How you ask?We both drive older cars and don’t eat out 3 times a week…Instead we save.Stop making us middle class peole sound like wimps and start saving.First get rid of your 500 a month leased car.That’s a step in the right direction..Kelly