Tax-free savings accounts are flexible, convenient but underused

Every year, as the March 1RRSP deadline approaches, Canadians are bombarded by last-minute reminders urging them to make a contribution, but it's good to keep in mind that there are other options when it comes to saving money for retirement.

The most popular alternative to an RRSP is probably the tax-free savings account, or TFSA, which the government introduced in 2009 and which many financial advisers say is the better option for middle- and low-income Canadians who want to put aside some of their income.

In the five years since they were introduced,TFSAshave grown in popularity, and today,morethan11millionCanadianshave one.

Of the people holding TFSAs in 2012,44 per centhad made their maximum annual contribution, according to apoll released by Bank of Montreal (BMO).

In 2013, theannual contribution limitincreasedto $5,500 and remainedat that level for 2014.The 2015 federal budget immediately increased the maximum allowable contribution limit to $10,000 a year -- an amount that will not be indexed to inflation in the future.

This means that ifyou've never contributed to a TFSA, you could deposit as much as $41,000 into a TFSA in 2015. Butstatistics compiled byInvestor Economicsshow that the average account TFSA balance as of June 2013was only $8,785.

TFSAs popular but not used effectively

Whileit'sapparentthat TFSAs are increasing in popularity, it's lessclear whether Canadiansare actually using them, or fully understand how they work. According to theBMO poll, more than a third of Canadians said they didn't know the differencebetween a TFSA and an RRSP.

"We've seen a trend upwards," said Serge Pepin, vice-president ofinvestment strategy at BMO Global Asset Management. "Both the government and financial institutionsfound there was so much confusion out there.It alsostill appears that theRRSP remains the most used [savings] vehicle."

Despite the lack of understanding that surrounds TFSAs, the numbers show that theyarestill attractive to income-earners. At the end of their first year of existence, TFSAs held a combined value of $17.4 billion in assets across five million accounts.By June 2013, the total asset amount had ballooned to$97.9 billion in11.1 million accounts, according to Investor Economics.

TFSA vs. RRSP

More flexibility

One of the keyreasons behind thepopularity ofTFSAs is the flexibility they offer.Moneydeposited in a TFSAcan bewithdrawn tax-free at any time, andincome earned within a TFSA doesn'taffect one's eligibility for federal income-tested benefits and credits such as Old Age Security, the guaranteed income supplement or the child tax benefit.

Those who have a TFSA have a wide range of options for how touse the money they put into the account fromstoring it in a high-interest savings account to investing it in more volatile instruments such as mutual funds, equities or listed securities.

The decisionof which type ofinvestment to make with TFSA funds depends on your personalshort- and long-term financial goals, says Pepin, since like RRSPs, TFSAs are just another tool that must fit within your overallinvestment and savings strategy.

If youknow thatyou want to savefor a trip or a new car in the next few years, then the best option is toput your TFSA fundsin a liquid asset,such as a savings account,guaranteed investment certificate (GIC)or a bond,Pepin said.

"If it's longer-term saving, you may be able to afford to go into riskier assets that would give you the potential for higher returns,"he said.

People who invest money inside a TFSAdon't get an immediate tax break the way they do with an RRSP contribution, but investments inside aTFSA grow tax-free.

TFSAsarealsogood for people who are looking for alternative places to shelter money, says Judith Cane, a money coach based in Ottawa.

"With the pension environment changing, from defined benefit to defined contribution, pensions aren't as rich," she said. "So,peoplesee the TFSAas a place that isn't going to attract tax right away."

The accounts can also prove useful to those who suddenly inherit money and need somewhere to put it.

"I've noticed there are people who are receiving inheritances, and they may not have the room inside theirRRSP to put that money so they can put it into their TFSA, and it will continue to grow on a tax-free basis,"Cane said.

Saving for a new home

Theflexibility of TFSAsallows Canadians to save for things other than retirement. YoungCanadiansin their 20s are increasingly using TFSAs to fund their first home or post-secondary education, says Jamie Golombek, CIBC's managingdirector of tax and estate planning.

"The TFSA allowsyou to pay tax on your employment or business earnings at your current tax rate, which could be low, use some of those after-tax funds to contribute to a TFSA, and then withdraw the funds tax-free later in life, when you may find yourself in a higher tax bracket,"he said.

First-time home buyers have traditionally used theHome Buyers' Plan(HBP) to help fund theirhouse purchase. That plan allowspeople to withdraw up to $25,000 tax-free from their RRSP and put it toward the purchase of a first home but requiresthem toput the money back into their RRSP over a period of 15 years. HBP participants must repay a certain amount each year if they don't wantit tocount toward their income.

With the TFSA,young peopleand home buyers have another option.

"For young Canadians with newly launched careers, RRSPs may not be the most effective route to retirement savings,"Golombek said."With an RRSP, you get a tax deduction at a low rate because you're in the lowest tax bracket due to your earnings. The money could then be withdrawn later, perhaps on retirement,at amuch higher effective marginal tax rate."

By contrast, withdrawals to the TFSA canbe repaid to the plan at any time, following the year of withdrawal.

"And unlike HBP repayments, failure to repay amounts withdrawn from a TFSA never result in tax on funds not repaid," Golombek said.