Investing in those TFSAs

BMO’s recently released annual Tax-Free Savings Account (TFSA) report includes some interesting insights into Canadians’ use of these investment accounts. But one of the big questions the report raises is whether TFSAs are a good investment for the average Canadian in the first place. According to the report, about half of Canadians had a TFSA in 2013 — a 23% increase over 2012. However, while the use of TFSAs has increased, knowledge about TFSAs does not seem to have followed suit.

Only one in 10 Canadians can identify eligible TFSA investments (cash, GICs, bonds, stocks, mutual funds and exchange-traded funds) and only two in 10 know the annual contribution limit ($5,500 for 2014 plus any unused room from previous years). TFSAs were introduced in 2009 as both a complement and an alternative to the well-known Registered Retirement Savings Plan (RRSP). The same investments can be held in both accounts and neither the annual investment income nor realized capital gains are taxable. TFSA contributions are subject to annual limits, like RRSPs, but are not taxdeductible, as are RRSP contributions.

For the average Canadian, TFSAs can be a good vehicle for both short-term savings and long-term savings, depending on one’s personal circumstances.

TFSAs can be great for older Canadians of fairly low incomes, approaching retirement and likely to have fairly low retirement incomes. RRSP contributions may result in tax deductions on the way in, but on the way out, RRSP withdrawals are taxable. Making contributions while earning a fairly low income doesn’t result in much of a tax benefit. And while withdrawing money when earning a fairly low income in retirement may also result in little tax payable, there are government retirement pensions and tax credits that may be reduced with every extra dollar of income in retirement. The result can be an effective tax rate that is much higher in retirement than the tax savings on the initial RRSP contributions. So the alternative — a TFSA — may be a better choice. And for those Canadians saving for the longterm, 1% returns on cash are disadvantageous as a result of year-over-year price increases (inflation). Even though Canadian inflation is rather low now at about 1%, cash is just barely keeping up.

So while more Canadians are opening and contributing to TFSAs and many are continuing to invest their existing TFSA savings, the big question Canadians need to ask themselves is if they should be contributing in the first place — or if they should be doing something different with what they already have in their TFSAs.