Wednesday, February 27, 2008

Tax-Free Savings Accounts (TFSAs) vs. RRSPs

The Canadian Federal Government introduced the tax-free savings account (TFSA) in yesterday’s budget. This is roughly the Canadian equivalent of the Roth IRA in the U.S. Canadians will be able to put up to $5000 per year into a TFSA. Any gains on investments inside a TFSA are tax-free.

The TFSA is similar to an RRSP in that the income from investments within the account are tax-sheltered. The main differences are as follows.

1. TFSA contributions do not give you a tax deduction. RRSP contributions are deducted from your income to reduce taxes.

2. TFSA withdrawals are not taxed. With RRSPs, any withdrawal is treated as regular income and is taxed.

A natural question is should you contribute to an RRSP or a TFSA? The answer depends on your tax rates. If your tax rate when you contribute money is higher than it will be when you withdraw money, then an RRSP is better. If your tax rate when you contribute money is lower than it will be when you withdraw money, then the TFSA is better.

Both RRSPs and TFSAs are better than investing in a regular account where any gains are taxed. So, if you are able to save enough, contributing to both RRSPs and TFSAs is the best option over the long term. Not paying taxes each year on investment gains is a huge advantage of both types of accounts.

An interesting difference between RRSPs and TFSAs is the perception of how much money you have. If you are in a 50% tax bracket, you will only get to spend half of the money in your RRSP. However, all of the money in a TFSA is yours to spend.

So, having $200,000 in an RRSP may feel better than having $150,000 in a TFSA, but it isn’t better (if you are in a 50% tax bracket). This psychological difference may make people happier with bigger dollar amounts in an RRSP even if they are better off with a TFSA.

As more details come out about TFSAs it will be interesting to see what kind of strategies become possible such as income splitting between spouses. If the TFSA is here to stay, it will provide big benefits for people who save money and invest wisely.

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