Photo by jpghouse.
The incentive to spend money is enormous: there’s always a bigger latte, a newer iPod, and a better apartment waiting around the corner. Saving money is laborious and—let’s face it—boring. Unfortunately, easy access to credit and rising property values have turned the West into a population of grasshoppers, just starting to get a taste of the financial winter coming. Although the new federal budget has underwhelmed, the government has provided an interesting way to save in the tax-free savings account (TFSA), set to start next year.
The TFSA allows Canadians to contribute $5,000 of their post-tax income annually into a special account where any gains or interest accrued won’t be taxable. The account is extremely user-friendly for two reasons. First, unused space for contribution rolls over, so that if you don’t have the money for 2009, for example, you can contribute up to $10,000 in 2010. Second, unlike an RRSP account, if a withdrawal is made from a TFSA, the value of the withdrawal is returned to the contribution limit so it can be contributed back later. If you contributed $4,000 in 2009, but pulled out $2,000 for an emergency, you would still be able to contribute $3,000 for that year.
Of course, actually having the $5,000 to contribute helps. The government suggests that Canadians in the two lowest tax brackets would soak up over three-quarters of TFSA benefits—presumably as lower-income Canadians could choose the new account over an RRSP account because of its flexibility in contributing and accessing money. However, criticism has arisen that the benefit is moot since many lower-income Canadians cannot afford contributing to TFSA.
If you’re deciding between contributing to your RRSP account versus the TFSA, the answer is yes. You’re best off contributing to both if you can. Otherwise, estimate the tax rate you expect to pay in the future. A contribution to a TFSA is more worthwhile if you expect your current tax rate to be lower than the tax rate when you withdraw the money—essentially the situation debt-free university students and new graduates are in. As well, there’s easier access to money in a TFSA since the tax has already been paid on that money. If you expect your current tax rate to be higher than the tax rate when you withdraw the money, choose the RRSP account. By deferring the taxes you’d pay on your contribution, you can take advantage of paying less tax at a later date.
A lot could change with a potential election coming up, but hopefully the TFSA sticks around for good. Any incentive to save is a good thing (unlike a GST cut, which promotes consumption). Contribute using money saved by choosing a smaller coffee, skipping a shopping trip, and holding off on an iPod that’s bound to be be outdated by tomorrow anyhow.
One more thing: if, instead of buying a now-archaic 1st-gen iPod, you had thrown $400 into Apple stock, you would have had about 45 shares—worth almost $9,000 at the end of 2007. If the shares were in a TSFA account, none of the $8,600 capital gain would be taxed and that’s some green, grasshopper.
Photo by OhioProgressive.