Are TFSAs only good for the rich?

Should lifetime contributions should be capped?

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by Larry MacDonald
February 1st, 2013

From the February/March 2013 issue of the magazine.

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Commerce, Toronto, Ontario, Canada
At the start of the year, the annual contribution limit for Tax-Free Savings Accounts rose by $500, allowing Canadians to shelter $5,500 in investments from tax each year, in addition to whatever RRSP room they may have. The Conservatives plan to go even further—if the federal government balances its books, something expected by 2016, it has promised to raise the TFSA contribution ceiling to $10,000 a year. But left-of-centre policy wonks oppose expanding contribution room. They say TFSAs favour the wealthy and lifetime contributions should be capped. Could they be right?

Indeed, there is data showing persons of modest means have a hard time scraping together cash for vehicles like TFSAs. For example, a U.K. study found only 5% of low-income earners used similar savings accounts in Britain. “The accounts are just another opportunity for the wealthy to shelter more of their investment income,” claim Robert Drummond and Chris Roberts, authors of Pension Confidential.

Moreover, as money in TFSAs grows, billions of dollars of forgone tax revenue may mean less funds for public services and the less fortunate, declares Armine Yalnizyan, an economist at the Canadian Centre for Policy Alternatives. “Expansion of the TFSA will only accelerate income inequality,” she says.

Yet, by promoting savings and investment, TFSAs have a vital role in increasing the size of the pie that can be divided up among all Canadians. “Savings, in economic terms, are the necessary precursor of capital investment, which in turn is the basis of economic growth and innovation,” notes C.D. Howe Institute economist Finn Poschmann.

Unlike fully taxable RRIF withdrawals, middle-class seniors benefit because TFSAs avoid the OAS clawback. Similarly, lower-income Canadians who are able to save can avoid clawbacks to GIS and other means-tested seniors benefits. Those as young as 18 with minimal RRSP room still get $5,500 annual TFSA room; they will benefit from a long time horizon, and be less dependent on government later in life. So while TFSAs do help the rich, there really is a benefit for Canadians of all ages and income levels.

9 comments on “Are TFSAs only good for the rich?

  1. Another argument in favour of the TFSA: as David Chilton points out, many people who contribute to RRSPs *spend the associated tax refund.*

    The RRSP is only efficient when the tax refund is reinvested.

    For a great illustration of this, see this link: http://worthwhile.typepad.com/worthwhile_canadian

    Reply

    • Yes, in effect the RRSP is equivalent to a leveraged TFSA, where the RRSP loan aspect is the so-called "tax refund." The effective interest rate on the tax refund loan is a function of 3 things: the rate of return on monies invested in the RRSP, the length of time the money is invested in the RRSP and the difference between the marginal tax rate at RRSP contribution time and RRSP withdrawal time. If you're interested in the demonstration of this fact, keep reading this and following comment.

      RRSPs as Leveraged TFSAs

      Everyone understands that returns earned in a TFSA are tax-free, as are returns in RRSPs until withdrawal time, when all withdrawn funds are taxed. However, most people think that RRSP investing is better than TFSA investing due to a tax refund gift from the government that occurs at the time of the RRSP contribution. This notion is completely wrong.

      Rather than a gift, the RRSP tax refund is a loan from the government – a loan paid back with interest as RRSP funds are withdrawn. The arithmetic of the interest rate charged by the government is a bit messy, but it depends on the rate of return the RRSP funds earn, the length of time the funds are invested, and the difference between the investor’s marginal tax rate at contribution time and at RRSP withdrawal time. Investing via an RRSP is precisely equivalent to leveraged TFSA investing, that is to say, investing in a TFSA account using your own funds plus a government loan.

      To see that the tax refund associated with an RRSP investment is in fact a loan arrangement with the government, let’s look at a simple one-year, $142.86 contribution to an RRSP earning 5%. Supposing the contributor’s marginal tax rate at the time of contribution is 30%, the tax refund would be 30% of $142.86=$42.86, leaving an out-of-pocket investment of $100 of the investor’s own money. The other part of the RRSP tax refund deal is that while the government will not tax any RRSP earnings (as in the case of TFSAs) while the RRSP is ongoing, the government will tax all of the RRSP proceeds at withdrawal time (unlike TFSA withdrawals, which are not taxed at all).

      Supposing the RRSP funds are completely withdrawn after one year, and that the tax rate applied at that time is, say 35%, the RRSP will have grown to 1.05 x $142.86 = $150, and the taxes paid would be 35% x $150 = $52.50. So for engaging in this RRSP arrangement, and taking the $42.86 tax refund (tax loan) from the government, the individual must pay the government back $52.50, which implies an interest amount on the tax refund loan of $52.50 – $42.86 = $9.64. This interest on a $42.86 loan for one year is $9.64/$42.86 = 22.5%. That’s much higher than the 5% the government loan money was earning while sitting in the RRSP. Consequently, in this instance a TFSA, which involves no government loan as part of the arrangement, would be much preferable to the RRSP. cont'd next comment.

      Reply

    • RRSPs as leveraged TFSAs cont'd.

      The effective tax refund loan interest rate paid to the government depends on the relative tax rates at contribution and withdrawal times, and also on the number of years between the date of contribution and the date of withdrawal. To examine more realistic possibilities, the table below shows both the net after tax wealth at the end of an investment horizon, and, in brackets, the effective tax refund loan interest rate involved in RRSP investing. For comparison, the net after-tax wealth position is also shown for a TFSA investment and for an investment made in non-registered (non-tax sheltered) form. In each case, $100 is invested at the beginning of each year for either 4 or 30 years. The before tax rate of return is 5%. The investor’s marginal tax rate at contribution time and throughout the whole period is 30%. The only difference among the three cases is the tax rate at RRSP withdrawal time, which is 30%, 35% or 20%.

      No. yrs. TFSA RRSP Non-registered

      Tax rate at time of RRSP withdrawal=30%
      4 $453 $453 (5%) $436
      30 6,976 6,976 (5%) 5,343

      Tax rate at time of RRSP withdrawal=35%
      4 $453 $420 (12.0%) $436
      30 6,976 6,478 (5.8%) 5,343

      Tax rate at time of RRSP withdrawal=20%
      4 $453 $517 (-11.0%) $436
      30 6,976 7,973 (2.7%) 5,343

      Since TFSA investments are truly tax free, different tax rates have no influence on the end of period after tax wealth. The same is true for non-registered investments, whose returns are taxed as earned. However, as you can see from the RRSP column, only in the case where the tax rate at withdrawal time equals the tax rate at contribution time (30%) is the effective tax refund interest rate unaffected by the length of the investment period, and is exactly the same as the return on invested funds (5%). In the top part of the table you can see that in this case, the RRSP investment (with the automatic tax refund loan) provides exactly the same after tax end of period wealth as the TFSA.

      The middle section of the table shows that when the tax rate on RRSP withdrawals (35%) exceeds the tax rate at contribution time (30%), the effective interest rate on the tax refund loan (12.0% and 5.8%) exceeds the rate of return on investment in the RRSP (5%), thus reducing the end of period after tax wealth below that of a TFSA.

      Finally, the bottom section of the table shows that if the tax rate at RRSP withdrawal time is less than the rate at the time of contribution, the effective tax refund loan interest rate is lower than the return on the loan money invested in the RRSP (5%). In fact, in the case of the 4-year RRSP investment and 20% tax rate on withdrawals, the effective interest rate on the RRSP tax refund loan is negative (-11.0%).

      Alex MacMillan, a retired university professor, is author of “The Least-risk Road to Retirement” and other financial planning tools found at http://www.personalfinancialplans.ca.

      Reply

  2. Good grief! Much of the gist of this is, "I won't plant one single tomato plant because I don't have enough seeds to be a farmer."

    Yalnizyan's argument against is: Poor people will become even poorer because the rich people will use exclusively so there won't be tax on that money as there normally would which to go toward social benefits? Somebody actually logic-ed that one out? …Must've been one of those sleepless nights in bed spent staring at the ceiling when the mind won't stop churning. Beauty. …Sounds like a massive, crazy stretch, but beauty.

    Reply

  3. Doesn't sound like a stretch to me.

    This lowers government revenue by helping people with money pay less tax. People with no money to shelter aren't helped at all. No stretch.

    Lowering government revenue could certainly have an impact on social programs that assist the poor. No stretch.

    I'd love to pay less taxes on my investments – the amount that the TFSA shelters is tiny. But let's not fool ourselves – if we're lucky enough to have the money to want to shelter, we're pretty fortunate in general. And for savers like me, that money is removed from the economy.

    By contrast, lower the tax rate on the lowest income bracket, and everyone benefits – and poor people will probably spend it, helping the economy.

    I've never been sick, but I'm grateful for the medical safety net.

    I've never been poor – but who knows what the future might bring.

    Reply

  4. All the wealthy people are producers of some kind of products, and products are to extract money from the pockets of others, so people who focus on production get wealthier and those who focus on money get poorer because money is to buy products.

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    • Nice philosophy by the way. It's hundred percent true.

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  5. Whether or not the TFSA existed, wealthy individuals would still find a way to shelter there investments. I believe that TFSA's have a positives impact on low income families because it gives that extra incentive to save.

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    • Rather than face the restrictions of a RRIF I have elected to move as much of my RRSP's to TFSA's as possible and would welcome the opportunity to move more. My biggest issue is the restrictions on what one can do with either RRSP's or TFSA's; given the chance, I would take my TFSA contributions and make a downpayment on an income property thus leveraging these funds and enjoying tax free returns – ahhh but we can only dream. lol

      Reply

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