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Weekly UpdatesIn 1957, the federal government introduced the Registered Retirement Savings Plan (RRSP) to encourage Canadians to save for retirement while benefiting from tax deductions. Before RRSPs, only individuals who belonged to employer-sponsored registered pension plans could deduct pension contributions from their taxable income. At that time, the RRSP was the biggest personal saving vehicle introduced by the government ... until now.
As early as 2009, the TFSA will permit Canadians to set money aside in eligible investment vehicles and allow the savings to grow tax-free.
How does an investment vehicle that allows you to grow your investments tax free differ from an RRSP? Although the TFSA appears to have the attributes of an RRSP, it is actually a hybrid between a non-registered account and a registered account.
The following outlines some of the similarities and differences between RRSP and the TFSA.
Tax treatment of contributions and interest deductibility
Contributions to a TFSA are not deductible in computing income for tax purposes and will not be taken into account in determining eligibility for income-tested benefits or credits delivered through the income-tax system. Contributions are made from after-tax dollars, with both the contribution and the investment earnings exempt from tax upon withdrawal. In consequence, funds from the TFSA can be withdrawn for any purpose and at any time without any tax implications. While considering the tax deductibility nature of the RRSP, which allows contributions to be tax deductible, funds from a registered plan can be withdrawn tax-free only up to $20,000 for education purposes (lifelong learning plan) and $20,000 tax-free for first time home buyer's plan. All other withdrawals (contributions or interest earned from contributions) are taxable upon withdrawal. Depending on the tax rates upon contribution and at withdrawal, the advantages of the RRSP of deducting taxes at contribution and the advantages of the TFSA of saving taxes at withdrawal can be very similar.
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While the RRSP investor saves taxes upon contribution, the net value of the investment can be similar to that of the TFSA at withdrawal.
Similar to the RRSP, the investment income within a TFSA will not be taxable and interest on money borrowed to invest in a TFSA will not be deductible in computing income for tax purposes.
Contribution limits
Starting in 2009, individuals 18 years of age and older will acquire $5,000 of TFSA contribution room each year. Allowable RRSP contribution is the lower of: 18 per cent of earned income from the previous year or the maximum annual contribution limit for the taxation year (RRSP contribution room for 2008, 2009 and 2010 are $20,000, $21,000 and $22,000 respectively) or the remaining limit after any company sponsored pension plan contributions.
Carry-forwards and withdrawals
Any amounts withdrawn from an individual's TFSA can be put back in the TFSA at a later date without reducing contribution room. This will give individuals who access their TFSA savings the ability to re-contribute an equivalent amount in the future. Furthermore, unused contribution room will be carried forward to future years.
A RRSP holder who cannot make maximum contribution one year can make up that portion of the contribution in later years by carrying it forward. A RRSP holder may also choose to delay claiming current year's RRSP tax deduction provided that the allowable deduction limit has not been reached. Also, unlike a TFSA, amounts withdrawn from a RRSP cannot be put back in the future.
Over contributions
Excess contributions to the TFSA account above the $5,000 limit will be subject to a tax of one per cent per month.
RRSP contribution beyond maximum allowable amount for a year is considered an over contribution. There is a lifetime allowance of $2,000 for over contributions. These contributions must be used before any new contributions are applied. Over contributions will be subject to one per cent penalty per month.
Qualified investments and collateralization
A TFSA will generally be permitted to hold the same investments as a RRSP. The RRSP qualified investment rules accommodate a broad range of investments, for example: mutual funds, publicly-traded securities, government and corporate bonds, guaranteed investment certificates, etc. However, to address certain concerns that arise from the special tax treatment of a TFSA, the 2008 budget does propose some limitations on TFSA investments.
Regardless of the investment type--unlike RRSPs which cannot be given as collateral for a loan, there will be no prohibition in the Income Tax Act on an individual's ability to use their TFSA assets as collateral.
While both the TFSA and the RRSP have benefits-depending on the desired investment objective, a financial planner or tax expert can show how to use the benefits of both investment vehicles to complement each other.
By Christian Kokorian, CMA
Christian Kokarian, MBA, CMA, works as a senior commercial account manager for a major Canadian bank. He also teaches finance for CGAs in a graduate certificate program at McGiLL University and participates as a guest lecturer on credit and cash-flow management at Concordia University.
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