TFSAs: Short-term Versus Long-term Savings

Back in 2009 when the government established the TFSA, Ottawa figured the account would be a prime savings vehicle for younger Canadians and the more established RRSPs would stay financially fashionable for older men and women.

In fact, the TFSA has become the undisputed champion of Canada’s government-assisted financial vehicles.

But how you use the account changes depending upon your age.

How it works

With the TFSA, the Canada Revenue Agency (CRA) takes off income tax before you shove money into the account. Savers benefit because the returns on that cash, such as interest or capital gains, accumulate tax-free.

And, since Ottawa has already taxed the money, the government doesn’t care when you withdraw the accumulated assets. This year, next year, in 20 years, the CRA is indifferent to the timing.

The amount of TFSA contribution room you have varies based on your age. But, overall, the TFSA is relatively straightforward financially speaking.

Something for the kids

For younger people, TFSA works wonders for three main reasons.

In Canada, younger people earn less on average than older Canadians. In 2010, for instance, English-speaking income earners aged 15 to 24 made $13,500 versus those 45 to 54 who pulled in almost $58,000.

So Ottawa takes less income tax as a percentage from the barely shaving crowd compared to higher income earners. Thus, a youngster can reach the same TFSA target, say $10,000, as an older person at a lower gross income level.

Also, the TFSA contribution limit is the same for everyone regardless of income (you can find your current limit using our TFSA room calculator). So, younger people don’t face lower contribution ceilings because they make less, as is the case under RRSP rules.

With decent incentives to squirrel away money at an early age, younger Canadians gain from the effect of compounding for a longer period.

For example, if you start with $1,000, add $100 a year for 40 years and, assuming a 5% rate of return, you end up with more money at 65 than a person who doubles the annual contribution to $200 but has only three decades to reach the same age.

Slow and steady always wins this race.

The compound interest math is well-known, but the TFSA has the added advantage of being flexible.

Younger Canadians often incur large expenses, say, a new car or a wedding. In such circumstances, they can dip into their TFSA without incurring extra income tax; remember the CRA already took its portion off the top, not when the cash is withdrawn.

More gold for the oldies

For retirees, the withdrawal math is more complicated but can still work in your favour.

The big advantage to RRSPs is the after-tax value of the contributions. Generally, you take RRSP cash out when you stop working. In many cases, you’re in a lower tax bracket upon retirement than when you were employed; so the resulting tax bill on the withdrawn RRSP cash is smaller compared to the after-tax earned income.

In this scenario, however, three problems pop up:

1. You have to pay income tax when RRSP withdrawals are made but not when you withdraw money from your TFSA. That’s because the government assesses taxes upon your entire RRSP withdrawal, both principal and accrued returns, while TFSA withdrawals aren’t taxable.

2. When you turn 71, you must convert your RRSP into a registered retirement income fund (RRIF). And you’re forced to withdraw a certain percentage each year, which might not be optimal financially.

3. RRSP/RRIF withdrawals are included in the calculation as to whether the government claws back any Old Age Security (OAS) and Guaranteed Income Supplement (GIS) payments you get; TFSA withdrawals aren’t subjected to the same rules. Basically, sheltering retirement cash in an RRSP makes sense if you have a lot of cash to eventually take out, not so much if you’re a lower-income retiree. Here, the middle-class older Canadian could face the clawback on their OAS or GIS payments.

The bottom line

Overall, whether you’re just starting out on the job or running for the workplace exit, a TFSA can make the most sense. As with all financial instruments, however, timing matters. But being smart with your money is timeless.