in 2009, Canadians got a financial gift from our government. The Tax Free Savings Account (TFSA) . At the end of 2022, almost 17.8 million Canadians had one or more TFSAs. Yet it continues to be one of the least understood, and most underachieving financial vehicle available! Time for a rethink of how we might use a TFSA to achieve the goals for which it was originally intended.
The government originally circulated the idea of a tax advantageous investing account as a means of encouraging Canadians to save for their financial goals. The Tax Free
Investment Account (TFIA), as it was originally called was applauded by all as a way to encourage long-term investing!
The original discussion paper talked about encouraging people to invest their money long-term and receive tax free the benefits of investing a portion of their wealth this way. Reviewers including taxpayer associations, small and large business organizations, and the C.D. Howe Institute provided significant support for the concept. The Canadian Bankers Association only asked for one change - that the name be changed from the TFIA to the TFSA.
Everyone else was not too concerned about this change, thinking that the marketing for the program would inform people how it should be used. Sadly, the government left the marketing to the companies who would provide the investments to market. Most Canadians only get financial advice from their branch. Saving on taxes seemed like a great idea, so extra savings were transferred into a TFSA, and taken out whenever needed. The TFSA became a "high performance" savings account.
The impact of this transition to an "improved" savings vehicle? A numeric example is probably best.
Johnny Canuck has received a gift of $10,000 and wants to use it as part of a down payment on a house. He knows it will be 10 years before he will have enough saved. If Johnny invests the money inside a TFSA and generates only 7% annual return for the decade, he will double his money, withdrawing approximately $20,000, of which $10,000 is a tax-free capital gain, Even at the lowest tax rate, Johnny will save just over $1000 in taxes when he takes the money out of the TFSA, compared to someone making the same investment outside of a TFSA. That's 10% of his original capital, and certainly worth considering.
What about using a savings plan? If we assume Johnny buys a 5 year GIC and renews it at the end of year 5, he can currently earn 3.3% from a major bank. At the end of 10 years, Johnny has $13,836, of which $3,836 would have been taxable income other than for the TFSA. Johnny's tax saving is about $770 at the lowest tax rate.
Johnny is much better off with the capital gain inside a TFSA than savings income. The benefit increases with the returns generated by the investment. At a 10% return, Johnny would have almost $26,000 and his tax savings would be $1675 and at 12% (the average annual return on the S&P500 for the past decade) he has just over $31,000 with tax savings of approximately $2200.
So TFSAs were intended as long-term investment vehicles and work best when used for longer term purposes. The higher the return generated by the investments inside the TFSA, the larger the advantage of using one.
If you have already read our article on What are RRSPs? you'll know that the benefits of an RRSP depend only on the difference between your marginal tax rate when you put the money into an RRSP and when you withdraw it. That doesn't apply to TFSAs - they benefit everyone, regardless of income.
Every Canadian should have a TFSA and be contributing to it as much as possible!
