Thursday, April 10, 2008

Secondary Effects of TFSAs

According to Newton, for every action there is an equal and opposite reaction. If the proposed Tax-Free Savings Account (TFSA) becomes law in Canada, we should expect reactions to the changes it will cause.

The main factor that determines whether TFSAs or RRSPs are better is tax rates. If your tax rate will be higher when you withdraw money than it was when you contributed money, then you should prefer a TFSA. Ironically, it is often the poorest seniors who fall into this category because of clawbacks.

As a senior’s income rises, the Guaranteed Incomes Supplement (GIS), the age credit, and Old Age Security (OAS) all get clawed back, which can make the effective tax rate very high. For example, a senior with an income of $12,000 who withdraws an extra $1000 from an RRSP or RRIF will pay an extra $780 in income taxes, mainly because of the GIS clawback. This is a tax rate of 78%.

Effective tax rates can be even higher due to other government programs with income tests. Having a higher income can make a senior ineligible for certain government programs.

With a TFSA, any money you withdraw won’t count as income. RRSP income can be clawed back with high tax rates, but this won’t happen with a TFSA. Or will it?

Current Rules vs. Possible Future Changes

Under current rules, withdrawing money from a TFSA wouldn’t trigger any clawbacks. But, there is no guarantee that things will stay this way. The GIS is intended to help very poor seniors. In the future, there could be seniors with substantial TFSA savings that generate a comfortable tax-free income. These seniors would remain eligible for the GIS if nothing changes.

The GIS is not intended to make well-to-do Canadians a little wealthier. Future governments would be tempted to change this situation. An obvious fix would be to take into account TFSA income in determining the amount of GIS a senior would receive.

Such a change would be politically unpopular, but there are many ways to make it more palatable. The GIS could be scrapped and replaced with a more generous program that includes tests for high TFSA income. Other creative approaches are possible as well.

I don’t claim to see into the future, but I think it is dangerous to assume that TFSA income will never be factored into clawbacks of government programs.


  1. As much as I love TFSA, I agree with you that the non-income tested rule is too good to be true.

    $5,000 per year for 25 years at 5% real return is $238,635. Enough to generate ~$12,000/year from fixed income assuming 5% interest. And that's only for one spouse.

    One solution may be to cap the maximum contribution.

  2. I agree about the GIS clawback perhaps becoming a reality.

    I suspect the TFSA was brought in without thinking of all the ramifications. It really does go against the idea of the GIS to allow TFSA-rich seniors to collect it.


  3. Probably true about the risk of clawback. Depends how popular TFSAs become. On the other hand, in 25-30 years I may not care, or be able to!