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Tax-Free Savings Account ideal as emergency backup fund

Globe and Mail Update

Amid some of the most abysmal financial conditions in decades comes the new Tax-Free Savings Account.

Fortunately, the TFSA is battle-ready. In fact, it's an ideal way to prepare yourself for the worst effects of a troubled economy.

Banks, brokers and other financial firms began offering TFSAs on Jan. 1, though many have been preregistering customers for months. Demand for TFSAs was described yesterday as “overwhelmingly positive” by Canadian Imperial Bank of Commerce. Online bank ING Direct said it was racking up about 2,000 to 3,000 new accounts a day, while discount brokerage BMO InvestorLine said about 85 per cent of new accounts opened in the past couple of days have been TFSAs.

This is the time of year when Canadians start to think about contributing to their registered retirement savings plans. Now, along comes the new TFSA to complicate matters. Need help deciding where to allocate your money? Let the economy be your guide.

In normal economic conditions, RRSPs should take precedence for the large majority of people who will retire to a reduced income level that puts them in a lower tax bracket than they were in while working. If you think your tax bracket in retirement will remain the same, then the TFSA and the RRSP are equally good. It's your pick.

In a recession, the TFSA demands a long look because it's such an ideal way to build an emergency fund based on a high-interest savings account or term deposits. This is especially true for people who have an eye on their RRSPs as a source of funds in case of a job loss or other financial disaster.

A Statistics Canada report from 2004 found that 39 per cent of people with RRSPs had made a withdrawal from their plan over a nine-year period. Almost half of those people who withdrew money did so again in another year, and one-quarter of them made withdrawals in three separate years during the study period. Note that withdrawals for the Home Buyer's Program, which aids people purchasing a first home, were excluded.

“There certainly are people who withdraw money from their RRSP for emergencies,” said Jamie Golombek, managing director of tax and estate planning for CIBC. “We caution them for three reasons.”

The first is the potential tax hit. While there's a withholding tax applied to RRSP withdrawals, it often doesn't cover the full extent of the tax owing on the amount taken out of the plan. If you don't plan for this, you may receive an unpleasant surprise when you do your tax return.

A second reason cited by Mr. Golombek is that the income from an RRSP withdrawal could limit your eligibility for the GST tax credit and the child tax benefit. A third reason is that you can't re-contribute money that you've put in an RRSP, even though you might have the wherewithal to do so at a future date.

“The TFSA,” Mr. Golombek says, “solves all of these problems.”

People 18 and older can save or invest up to $5,000 a year to a TFSA and pay no tax on their gains or any money withdrawn from the account. That's one advantage over RRSPs.

Another is that withdrawals from TFSAs won't affect your eligibility for tax benefits tied to income. Still another is that the money you withdraw from a TFSA can be put back in later.

Mr. Golombek said he has long advocated using a secured line of credit – where you borrow against the value in your home – as a source of funds in a financial setback. His reasoning: Interest earned in a traditional emergency fund is taxed like regular income. The TFSA eliminates this issue, which in his mind makes it an ideal platform for an emergency fund.

This brings us back to the question of RRSPs or TFSAs. If you don't have a credit line to bridge you through a financial setback like a job loss and you lack an emergency fund, then consider contributing to both.

Ideally, you'd max out your RRSP contribution and then put the maximum $5,000 into a TFSA as well. If this isn't possible, then consider dividing whatever funds you have available into contributions to both an RRSP and a TFSA. Note: You won't get a tax deduction for your TFSA contribution like you do for the RRSP. The payoff is that TFSA withdrawals are tax-free, unlike RRSPs.

TFSAs can hold the same wide range of investments as an RRSP, but this is a moot point if you're using your tax-free account as an emergency fund. Safety comes first in this situation, which means you should avoid the stock markets and anything else that could fall in value and thus deplete your account.

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