Friday, April 11, 2008

More Consequences of TFSAs

An interesting consequence of the proposed Tax-Free Savings Account (TFSA) is a short-term increase in income taxes paid by Canadians. Let me explain.

Money contributed to RRSPs is untaxed until it is withdrawn. Any money contributed to a TFSA is taxed immediately. Once the TFSA becomes law, some of the money that would otherwise have gone into RRSPs will go into TFSAs instead. This increases the amount of income tax governments collect in the short term.

In the short term, almost all retirement savings withdrawn by Canadians will come from RRSPs and RRIFs. So, the government will collect taxes on part of new savings and almost all withdrawals.

Eventually, all this will balance out. Suppose that half of new retirement savings will go into each of RRSPs and TFSAs. In the short term, most of the money coming out of retirement savings will be coming from RRSPs and RRIFs and will be taxed. Over time, though, the mix of money being pulled out of retirement savings will shift to half coming from each type of account.

Money can be addictive

It will be interesting to see how governments react when this short-term burst of extra taxes disappears. I’d like to think that the government will anticipate this effect of TFSAs and will pay down debt instead of getting addicted to the extra money. How likely is that?

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