The Federal Government introduced the tax free savings account in their last budget. Basically any Canadian citizen over the age of 18 can open an account and is allowed to deposit $5,000 per year. Any unused portion of the $5,000 in a given year can be carried forward. The account has no impact on RRSP yearly contribution eligibility. All income earned by the funds in the account are tax free and can be taken from the account at any time.
RRSPs have been the most widely used form of saving for retirement. People like you and I blindly scramble towards the end of February each year to purchase RRSPs from our bank or financial planner so that we can get a small tax break. The majority of people investing this way do not have any idea what their RRSPs are actually being invested in. In many cases when the funds actually do show a return, that return sits idly in the RRSP account and is not put back to work earning more dollars for the investor. Many people are in for a shock when they retire as taxes can reduce the face value of the RRSP account by as much as 39%. Imagine planning to have a million dollars to carry you through your retirement years only to find out that after taxes you actually have $610,000. The other consideration that one must look at is the fact that the RRSPs are usually purchased with after tax dollars and those same dollars are taxed again when the account is liquidated.
Bankers are programmed to sell RRSPs and are generally quite good at it. They however, have failed miserably in selling the tax free savings account product. The returns offered on tax free savings accounts by the banks are nominal at best and in many cases just cover the bank fees on the account. A number of investment companies offer products with higher yields and should be considered as a legitimate alternative.
The best way to compare RRSPs to the tax free savings account is by way of an example:
The client has decided to invest $5,000 per year for the next 5 years at which point the investment will be cashed in. The rate of return for both products is 7.0%. The example assumes that the client will reinvest yearly earnings. The tax rate used is 39%.
RRSP TFSA
Year 1 $5,350 $5,350
Year 2 $11,075 $11,075
Year 3 $17,200 $17,200
Year 4 $23,754 $23,754
Year 5 $30,767 $30,767
Taxes on the RRSP balance will be $11,999 leaving the client with $18,760 for his 5 year investment of $25,000. As there is no tax on the tax free savings account the ivnestor will have $30,767 from his $25,000 investment. One might argue that the tax deduction created by purchasing an RRSP should be part of this equation. However, then one would have to calculate the initial income tax paid to earn the investment funds. These numbers basically cancel each other out.
The bottom line is that the federal government has provided Canadians with a way to accumulate tax free dollars. In order to take full advantage of this product the general public will have to consider alternative investments offered by private investment companies.