TFSA becoming a tax-saving dynamo – if you have the cash

First the good news: The Canada Revenue Agency has allowed Tax Free Savings Account (TFSA) holders to put another $5,500 in their accounts in 2014. The total contribution room for anyone who hasn’t contributed to the TFSA since it was introduced in 2009 is now $31,000. The CRA is expected to boost the contribution limit by at least another $5,500 the following year, and each year after.

That means starting in January, up to $31,000 in just about any kind of investment can generate tax-free gains, giving the TFSA the breadth to create entire tax-free portfolios. Investors can initiate strategies to maximize returns and limit risk by diversifying across sectors and geographic regions, and tuck a portion away in fixed income for safety. More sophisticated investors can even dabble in derivatives.

Now the bad news

You have to come up with the maximum contributions to get the full benefit of the TFSA. For most Canadians overburdened by debt and trying to make ends meet day-to-day, that’s not going to happen.

The CRA doesn’t keep regular tabs on how much we’re tucking away in our TFSA’s on a national level but they do have a few telling facts. At the onset of 2013 more than nine million Canadians had tax free savings accounts – less than half of eligible Canadians 18 years or older. At last count the Canada Revenue Agency estimated the total value of assets in all TFSAs at $62 billion.

That means the average tax free savings account had a value of $6,900. A spokesperson for the CRA says that includes any gains on the contribution, which likely puts the average total contributions over the past four years well below the $31,000 limit.

Tax free savings account limits are becoming as pointless for most Canadians as registered retirement saving plan (RRSP) limits. The maximum RRSP deduction limit for the 2013 tax year is 18 per cent of earned income up to $23,820. A recent Sun Life Financial/Ipsos Reid poll found only 36 per cent of eligible Canadians even make contributions to their RRSPs. Another recent Bank of Montreal survey found the average RRSP contribution last year was only $4,670.

TFSA or RRSP

For the overwhelming majority of Canadians it comes down to choosing between putting their saving in a TFSA or an RRSP. If you’re one of them here’s something to keep in mind:

While an RRSP contribution generates an immediate tax refund, all contributions and gains are fully taxed when they are withdrawn in retirement. You will eventually be required to withdraw a minimum amount. If your RRSP generates big returns you will be taxed in a higher bracket, and you could end up paying as much as you saved, or more, in the end.

Even if your RRSP generates modest returns there is a real risk income tax rates will be higher in the future. Right now the Federal government is struggling to balance its budget by 2015 and some provinces, including Ontario and Quebec are drowning in debt. As Baby Boomers live longer in retirement, pressure will grow to generate revenue from those with taxable income.

A TFSA, on the other hand, doesn’t provide an immediate tax break but contributions and gains are never taxed.

The best solution is to split your contribution between both, starting with your RRSP. As an example, if you earn more than $43,000 a year you are taxed on a Federal level at 22 per cent. Anything below that is taxed at 15 per cent. Contributing anything over $43,000 to your RRSP will result in a 22 per cent refund. That refund, and any other money you can come up with, can go into your TFSA.

When the funds are withdrawn in retirement, the RRSP portion of your living expenses will be taxed in a lower bracket, and the rest from the TFSA is – like the name says – will be tax free.