TFSAs, RRSPs and the tax hikes to come

A bit of personal finance advice to see you through the decades ahead: Fill your TFSA. Fill it to the brim.

Tax-free savings accounts are the most universally loved franchise in the Canadian money universe, which suggests a certain redundancy in urging people to exploit them to the max. But as popular as they are, TFSAs are under-used. If governments raise taxes in the years ahead to help pay for their pandemic spending, your best defence is having a topped-up TFSA.

Speculation about higher taxes ahead has already begun, even though the economy is too fragile right now to support them. People must be encouraged to spend right now and higher taxes would discourage that.

But with Ottawa, the provinces and cities spending hundreds of billions more in total than they’re taking in, tax increases seem inevitable.

Speculating about tax hikes makes a strong case for using TFSAs. You contribute to these accounts with after-tax dollars and then you’re done, tax-wise, as long as you follow the contribution rules. Investment gains in your TFSA are tax-free, and so are withdrawals.

Expect the TFSA versus RRSP debate to intensify in the years ahead. A registered retirement savings plan works well if you have a tax rate in retirement that is lower than when you were working. The thinking here is that the tax break you got for making the RRSP contribution would be larger than the tax hit on money withdrawn from your RRSP or, once you turn 71, registered retirement income fund.

TFSAs are a good choice if you expect a higher tax rate in retirement, possibly because you have yet to reach your peak earnings years. TFSAs also work well for people concerned that their retirement income will be high enough to trigger a clawback of Old Age Security benefits. RRSP or RRIF withdrawals count toward the clawback threshold, but TFSA withdrawals do not.

There’s a lot going on in the world today in all respects, but financially in particular. We’re still figuring out how badly the economic lockdown caused by the pandemic has hurt people in terms of lost jobs and income. In the background, stocks crashed and then soared, interest rates plunged, gold prices surged and inflation tanked, except for pockets where the cost of living is pushing noticeably higher.

If your reaction to all these financial storylines is to disengage or back away, consider that bit of advice we started out with. Fill your TFSA to the brim.

You won’t regret it, even if an RRSP might turn out to be the better choice in terms of reducing total taxes paid over a lifetime. Even when RRSPs function well, people freak out about the taxes they have to pay as retirees. Tax-wise, TFSAs are friction-free.

Sure, there’s a risk that the federal government could change the TFSA rules. But slapping a tax on withdrawals of money faithfully committed for years to a TFSA is the sort of breach of faith that gets governments punted out of office. It would be smarter to focus changes on future TFSA contributions – perhaps by introducing a lifetime limit.

As appealing as TFSAs are currently and in a future sense, they’re still widely under-used. Federal government numbers for 2017, the most recent year available, show that the average amount of unused contribution room was $30,947 and the average fair market value for TFSAs per person was $19,633.26. As of 2017, total TFSA contribution room stood at $52,000; for 2020, the cumulative limit is $69,500.

There were 14.1 million TFSA holders in 2017, but 5.9 million of them did not make a contribution and only 1.4 million made the maximum contribution.

Unused TFSA capacity is a symptom of income inequity as much as anything. But if you do have money to invest, filling your TFSA is a smart way to prepare for a future with higher taxes.