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Putting new Tax-Free Savings Account to good use

Globe and Mail Update

Okay, let's make one thing clear: It's not going to rival sliced bread, the hula-hoop, the light bulb, chewing gum, the telephone, the Barbie doll, television, the printing press, traffic lights, or even the world-famous Veg-O-Matic. Gosh, the idea isn't even new. It was borrowed from the United States where these things have been around for years. I'm talking about the new Tax-Free Savings Account (TFSA), which will hit the shelves here in Canada on Jan. 1 – not quite in time for Christmas, but don't let that stop you from putting a TFSA under the tree this year.

TFSAs will be available to any Canadian resident age 18 or older. You'll be able to contribute $5,000 annually (the amount will be indexed in the future) to a TFSA, and while you won't receive a tax deduction for the contributions, the funds can grow tax-free inside the account, and all assets in the account can be withdrawn free of tax at any time. If you make withdrawals, it's much like “borrowing” the money from your TFSA because you'll be entitled to put that money back into the account later, along with any new contribution room you accumulate over time (i.e. $5,000 annually).

This is all good, but I'm most interested in how Canadians might use the TFSA to their advantage. And so, this week and next I'll share some creative ways you might consider using the TFSA. Before we begin, let me say that I think everyone should open a TFSA. The ways to use a TFSA will multiply over time as Canadians gain experience with them, and the flexibility makes them a no-brainer. Now, consider the following ideas.

Create emergency savings. Any good financial planner will tell you that it's prudent to have at least three months' expenses set aside as an emergency fund. If you haven't made this a priority in the past, the TFSA provides an opportunity to hop on the bandwagon and begin that emergency fund.

Save for specific purposes. Start thinking about specific goals you might have, put a dollar amount to those goals, and start setting aside money in a TFSA to pay for those things. Perhaps it's a home you'd like to buy, a car, an education for you or someone else (more on this in a minute), a wedding, vacation, a home renovation, or something else. You might as well use the tax-sheltering of the TFSA to save for these things.

Supplement retirement savings. If you've been diligent in using up contribution room offered by your registered retirement savings plan to the point where you haven't got any RRSP contribution room left, you can supplement those savings by contributing to a TFSA.

Alternative to RRSPs. You may be wondering whether it makes sense to replace your future RRSP contributions with contributions to a TFSA instead. I wrote about this at length in my article dated Feb. 28, 2008 (which you can find at www.waterstreet.ca). The bottom line is that the after-tax benefit of RRSPs and TFSAs are basically the same, which means you could use either one and be equally well off.

This conclusion assumes that your marginal tax rate remains constant over time. If you have a lower income today and expect your marginal tax rate to be higher in retirement, then the TFSA offers an advantage over RRSPs, and you'll want to save in a TFSA first, then top up your savings with contributions to an RRSP.

But if your income is relatively high today and you expect your marginal tax rate to be lower in retirement, an RRSP offers an advantage over TFSAs. As a practical matter, you'll likely want both an RRSP and TFSA, but this guidance I've given today should help you decide which plan you should contribute to first.

Save for education. A TFSA can be an effective tool for education savings. Unlike a registered education savings plan (RESP), there is no tax to pay on withdrawals. Having said this, RESPs should be your first choice when saving for the future education of a child. The reason? You'll want to take advantage of receiving the Canada Education Savings Grants (CESGs) which are available when contributions are made to an RESP for an eligible child. This is free money from the government, and enhances the growth of the RESP, so don't forgo this benefit. Once you've contributed enough to get the full CESGs, however, saving in a TFSA for education does make sense.

Stay tuned for more ideas next week.

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