Starting next year, you'll be able to contribute $5,000 annually to a Tax Free Savings Account (TFSA), courtesy of the new Conservative federal budget.
No doubt, this new savings account was introduced so that the Conservatives could at least be shown to be partially addressing their 2006 pre-election promise to eliminate capital gains tax when the proceeds are reinvested.
The TFSA is essentially a "tax prepaid savings plan" -- the term used by the Liberal government when it announced in its 2003 budget that it was studying the merits of such a plan. (That government never followed through.) "Pre-paid" refers to the fact that the tax on the contributions is paid in advance.
The move addresses the double taxation problem associated with savings in Canada: You pay tax when you earn income and then pay tax again on the appreciated income or growth when it's time to spend it.
The No. 1 question on everyone's mind is: Assuming you've got limited funds, which one do you choose --TFSA or RRSP?
The two plans are meant to be tax-neutral. The chart above compares the after-tax accumulation over 20 years of $5,000 in employment or business income earned by an individual, subsequently invested through a TFSA or an RRSP.
In the TFSA scenario, the $5,000 is taxed upfront, when earned, at the individual's marginal tax rate (assumed to be 40%) and the aftertax amount of $3,000 is invested in the TFSA. Since this tax is literally "pre-paid" and since the earnings and growth inside the TFSA are not taxed during the accumulation phase, nor are they taxed upon withdrawal, the after-tax value after 20 years, assuming a 6% growth rate, is $9,621.
In comparison, take the example of $5,000 of income that you don't pay tax on because it is put into your RRSP and a deduction is claimed for it. The $5,000 invested grows to $16,036 and is ultimately taxed upon withdrawal in 20 years at 40%. You net exactly the same amount aftertax, or $9,621.
So, while it appears that the two plans produce the same results, that only holds true if your upfront tax rate is the same as your tax rate later on.
RRSPs will make more sense when the tax rate upon withdrawal is expected to be lower than the tax rate upon original contribution. Conversely, TFSAs will work out better if your tax rate (including the effect of RRSP withdrawals on benefits such as the Guaranteed Income Supplement or the Old Age Security, which are clawed back based on income) will be higher upon withdrawal than it was when you contributed.
But the math doesn't tell the full story, since TFSAs are much more flexible. For example, the savings withdrawn can be re-contributed back into the TFSA later on. This can't be done with RRSPs.