The new TFSA, available as of Jan 1, 2009, is a great tool for many Canadians. It’s an account where you can hold almost any type of investment (GIC’s, mutual funds, stocks, etc.), without having to pay taxes on your interest, dividends or gains.  It differs from an RRSP in that you get no tax deduction when you make contributions to it and you will pay no taxes when you withdraw from it.

The Catch

As great as the TFSA is, it adds a new layer of confusion for many people and further complicates the RRSP vs Mortgage debate. Here’s a quick summary that should help you decide if this product is for you or if an RRSP or other option is better.

RRSP vs TFSA

If you were to contribute to your RRSP account at the same tax bracket that you expect to withdraw from it at, then the end result would be technically the same as if you had used the TFSA instead.  The RRSP is only more beneficial if you expect to withdraw from it at a LOWER tax rate that you contributed at. This is a key point to understand.

Many Canadians, however, will indeed withdraw at a lower rate, so in their case, they should favour the RRSP over the TFSA.

So Who Is the TFSA Best For?

1. People who are in lower income tax brackets (generally lower than 31%, or $38k per year) and especially if they have no children (see other article on RRSP’s for lower income Canadians to see why RRSP’s benefit higher incomes the most, in general.
2. People who have maxed out their RRSP.  After maxing that out, the TFSA then becomes the clear second choice.
3. People who have good pension plans.  If you have a secure pension that will replace a good portion of your pre-retirement income, then you may want to favour the TFSA over an RRSP. The reason for this is that a good pension will likely put you into the same tax bracket as you were when working.  In some cases, even higher, due to clawbacks!  If you think you might fit this category, you may want to consider maxing out the TFSA first, then contribute to your RRSP second.

Wait, There’s More!

Another consideration when deciding if you should use a TFSA or not is what you plan to keep in it and how long you expect to hold the investment.

If it is long term savings and you only plan to keep your investment in something like an interest savings account, you may actually be better off to not use the TFSA at all and just put that money against any debt you have.  Even though it is tax free, earning 3% interest would not be any more beneficial than paying down even a mortgage at 5%.

The Final Verdict on TFSAs

So the TFSA should generally be used for either short term savings or be used to hold investments with higher expected returns.  Unless you have no debt, of course!

Hopefully that helps you understand the TFSA a bit better.  Feel free to ask any questions in the comment section below.

Also, be sure to watch for an upcoming article on using your TFSA as another arbitrage opportunity.