Tax-Free Savings Account, Registered Educational Savings Plan, or RRSP

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Have tax-burdened Canadians once again witnessed an altruistic act of generosity by a government in power?  With the new TFSA that  started January 1, it looks like lightning has indeed struck twice in the last two decades.

The first time in my living memory of paying taxes (I started filing in 1977) occurred in 1998 when the federal government introduced a 20-per-cent grant to those families saving for their children’s education.

You read that right. If you have school-aged children or grandchildren and wish to save funds to pay for post-secondary education, the government will provide a matching grant of 20 per cent up to a maximum of $500 per year per child to a life-time maximum of $7,200 per child. There is an increased grant of up to $600 per year for low-income families. This is free money!

How can this be, you might ask? Well, during the 1990s, the federal government began cutting funding to post-secondary education and, according to a Statistics Canada estimate, the cost of a four-year post-secondary education will skyrocket to over $100,000 in the next 20 years. Quite a princely sum for most Canadians, but it may explain the seemingly altruistic generosity of the educational savings grants. But this is not the first time Canadians have felt the generosity of their government since the temporary introduction of personal income taxes in 1917.

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A long time ago (1957), in a place not too far away (Ottawa), a government felt it necessary to provide all of its citizens with an equal opportunity to self-fund their retirement income. Prior to 1957, only Canadians with pensions could claim a pension income deduction. The federal government introduced the RRSP to level the tax playing field. All working Canadians now had the chance to create a retirement fund and make use of the pension income deduction.

It was a bold plan designed to herald a new era of retirees flush with investable assets generating their own income for their retirement years. It would reduce dependence on government-sponsored social security plans and ensure Canadians a high standard of living.

At first, it seemed like a great idea. Low contribution limits meant that governments of the day would forego only a small loss in annual income collection, while the taxation minions rubbed their hands in glee over the future tax receipts.

Five decades later, government officials are still stymied by the low contribution rates. According to Statistics Canada, only 31 per cent of eligible taxpayers contributed to a plan in 2007, and those contributions accounted for just six per cent of the total available contribution room.

In my opinion, low levels of disposable income, high personal tax rates, and high personal debt levels are the primary factors behind the low contribution levels. Despite some of the drawbacks, Canadians should make every effort to make RRSP contributions and save for their retirement. The contribution limit is 18 per cent of earned income to a maximum of $21,000 for 2009. The limit is for individuals who do not belong to a pension plan. The government of Canada has also extended the age limit to the year in which the contributor reaches 71.

Now if that isn’t enough to confuse Canadians on how to allocate their meager disposal assets, the government has introduced a new and potentially beneficial type of savings plan. It’s a vehicle designed to motivate Canadians to save more, and it’s called the Tax Free Savings Account or TFSA. It has many features and benefits along with some limitations.

Contributions are made with after-tax dollars similar to an RESP (no tax deduction). Contribution limits are $5,000 per year for Canadians 18 years or older and any unused room can be carried forward into future years. Withdrawals do not impact your contributions and you can return any withdrawals without penalty. More importantly, there are no attribution rules. This means you can loan spouses and adult children funds to make contributions without fear of taxation reprisals. In addition, none of the income earned within a TFSA is taxable and withdrawals do not impact your taxable income in the year in which it is withdrawn.

So how do you allocate funds given these three government-sponsored initiatives. First, create a budget and balance sheet for you and your family. Look at your sources of income and expenses, and then prioritize your goals for current living and retirement income.

For those with children, my view is to contribute what you can afford to an RESP and collect the benefit from the 20-per-cent savings grant. I would then allocate on a 50/50 basis equal amounts into the TFSA and an RRSP. Once you have maximized the $5,000 contribution to the TFSA, the balance of savings should be allocated to your full RRSP contribution limit.

Finally, investors need to choose appropriate investments for the new TFSA, and herein lies the potential boondoggle conundrum.

Investments provide investors with three sources of income: interest income, dividend income, and capital gains. Since interest income attracts the highest relative level of tax, rational investors would tend to allocate TFSA assets into interest-bearing investments. However, with rates at historically low levels and given the annual cap of $5,000, it may take several decades before any meaningful sum becomes available for withdrawal purposes. As a result, many Canadians may choose equity investments in hopes of earning better rates of return in their TFSA.

Other investors may treat this new savings vehicle (with its $5,000 annual limit) as a speculative tool and place all of their speculative assets into the plan in the hopes of hitting a financial home run. Ten years of swinging for the fences may result in a significant negative growth rate and these speculative investors may find their TFSA accounts with significantly less than they have contributed.

Hopefully, many other Canadians will choose a more conservative balanced approach and will have a tidy nest egg of $50,000 plus modest growth that can then be used to augment their current lifestyle or retirement. Overall, I would strongly advise Canadians to make use of this savings account.