New Tax Free Savings Account is so good we bet it won’t last

The Tax Free Savings Account is the best opportunity for investors today to minimize tax during their life, and into retirement.   The younger an investor is, the greater the benefit of the TFSA.  The long-term benefits of the TFSA seem almost too good to last.   The government has stated that withdrawals from a TFSA are tax-free.  Not only are they tax-free, they will not impact income-tested benefits, such as the guaranteed income supplement or Old Age Security claw back.

In 2007, the mandatory RRIF conversion age was moved from 69 to 71, with the first required minimum payment at age 72.  Pension splitting was also introduced in 2007.  Another minor benefit was the increase to the pension income amount from $1,000 a year to $2,000 a year.  This essentially allows investors to pull $2,000 out of a RRIF account each year tax-free beginning at age 65 (assuming that the pension income amount is not applied to other eligible income).  People should modify their financial plans based on the above announcements and new TFSA.

By combining all the factors noted above, the benefits for people who have a savings plan in place are excellent.  We will use Stephen, who turned 19 on January 1, 2009, to illustrate our point.  In our calculations, we assume inflation of three per cent and annualized rate of return on investments of six per cent.  We also assume that Stephen’s ten highest earning years will be when he is 55 through 64 (when he is in the 30 per cent income tax bracket).  Stephen plans on retiring on his 65th birthday.

Early Years

Stephen should contribute the maximum amount annually to his TFSA every year beginning at age 19 until age 64.  If this discipline is set early Stephen will have accumulated close to $1.9 million in his TFSA by his 65th birthday.  Between 19 and 31, any extra savings should be accumulated for a down payment on a home.  By purchasing a personal residence Stephen will be taking advantage of one of Canada’ best tax-exempt investments.  When Stephen is 30 he meets Sharon and they soon get married.  Sharon is the same age as Stephen.  For illustration purposes, and to keep this scenario realistic, we will assume that they only have the cash flow to fund Stephen’s TFSA (or half in each).

Age 31 – 56

Together they buy a home when they turn 31.  In their middle earning years they should focus on first paying down the mortgage.  By removing their non-deductible debt as soon as possible, they will save thousands of dollars in interest costs.  Assuming a 25-year amortization schedule, they will be mortgage free when they are 56 years old.  Sharon has twins when she is 36 years old.  Sharon has directed some of her excess savings into starting a family Registered Education Savings Plan (RESP) for their children.  During this period we recommend contributing $2,500 for each child for fourteen years to maximize the Canada Education Savings Grant of $7,200 per child.

Age 57-64

After the mortgage is gone and RESP contributions cease, Stephen and Sharon will have a little extra cash flow.  Both Stephen and Sharon should redirect the cash flow previously dedicated to mortgage payments and RESP contributions to making their first RRSP contributions.  We assume Stephen has the higher income.  In today’s dollars, we recommend he contribute approximately $7,000 for six years between the age of 57 and 62.  This should fund two life annuities beginning at age 65 paying $2,000 a year each.  This is equal to the pension income amount and should essentially be tax-free.  The cost of these contributions is approximately $4,900 annually as Stephen will receive a tax refund of $2,100 for each of the six years (30 per cent x $7,000).

Retirement

When Stephen and Sharon are 64 they should convert their RRSP accounts to RRIF accounts and schedule to take their first payments at age 65 ($2,000 per year each).  Both should apply for Canada Pension Plan (CPP) retirement benefits.  Stephen is eligible for the full CPP; however, Sharon worked part time and qualifies for a lower CPP amount.   Stephen and Sharon should make an application to share CPP, this will reduce the household tax liability.  In addition, they should both apply for OAS to begin once they turn 65.

At the beginning of retirement, Stephen and Sharon will have accumulated approximately $1.9 million in their TFSA account.  Readers should factor in inflation when looking at this number.  $1.9 million in 46 years will not be worth the same amount as it is today.  With a three per cent real rate of return, the equivalent amount (in today’s dollars) is approximately $488,000.  In today’s dollars, Stephen and Sharon will also have $26,900 and $28,500 in their RRIF accounts, respectively.  If we assume that both Stephen and Sharon have life expectancies of 90 years, then the TFSA should fund annual tax-free cash payments of approximately $137,600 (the first payment is approximately $35,173 in today’s dollars).  If Stephen and Sharon were both able to take advantage of the TFSA then the TFSA should fund annual tax-free cash payments of approximately $275,200 (first payment is approximately $70,346 in today’s dollars).  In addition, they will also each receive income from CPP, OAS, and the RRIF annuity.

The TFSA brings planning for low taxable income at retirement to new levels.  People who use the TFSA will pay more annual taxes during their working years from not maximizing RRSP contributions.  This sacrifice will be rewarded at retirement when taxes will be extremely low.  Stephen and Sharon will not have to worry about having their old age security being clawed back.  In fact, if they plan right, their income may be low enough to qualify for medical benefit assistance and/or other income tested benefits.  Better yet, they may qualify for the tax-free guaranteed income supplement (GIS).

After doing the math we came to the conclusion that the TFSA is such a good deal for Canadians that it likely will not last long term in our opinion.  If it does last more than ten years then possibly some of the rules will change.  In the meantime, it makes sense to consider how the TFSA can benefit your overall retirement savings strategy.