It took a couple of years to work out the kinks, but tax-free savings accounts are proving to be a rabidly popular savings option for Canadians, with some financial advisers now recommending them over the stalwart RRSP.

Among the top reasons for the rise in popularity of TFSAs is their flexibility. Money can be pulled out without penalty in case of a financial emergency, TFSAs don't have to be converted into a RRIF upon retirement, and they can contain a variety of different types of investments. Investors don't get an immediate tax break the way they do with an RRSP contribution, but investments inside a TFSA grow tax-free.

And now that the total contribution room has expanded to a healthy chunk of cash — $20,000 in principal as of 2012 — TFSAs are becoming a viable way for investors to play the stock market, tax-free.

But be careful: While the rules governing TFSAs are simpler than those for RRSPs, there are still regulations around withdrawing and transferring funds that can snare the unwary. And there are penalties on excess contributions, too.

Bumps in the road

When the TFSA was launched in 2009, the Conservative government heralded it as "the single most important savings vehicle for Canadians since the launch of the RRSP" in 1957. But federal officials didn't anticipate the bumpy road they would face in the early years as people familiarized themselves with TFSAs.  

Too many savers thought the TFSA — which allows a person to put up to $5,000 a year of after-tax money into GICs, mutual funds, bonds, stocks or savings accounts and earn profit tax-free — worked like a bank account with a maximum balance. In 2009, about 70,000 people withdrew money from one of their TFSA accounts and then redeposited it the same year.

But when you withdraw funds in one year, TFSA rules don't let you redeposit them until the next, so the Canada Revenue Agency levied penalties of one per cent per month on redeposits that were classed as excess contributions. The government eventually relented because of the widespread confusion, and rescinded the penalties in 2010 for people who accidentally put too much into their accounts during the TFSA's debut year.

The amnesty is over now, however, and savers can't expect that kind of pity from the tax collector anymore. If you want to move your money from one account or institution to another within the same calendar year, you have to use a formal transfer process that requires filling out forms and, with most banks, paying a fee.

Another headache for the government was the fact that some devious investors pumped their accounts full of penny stocks and used other schemes designed to take advantage of the TFSA's tax breaks. The government cracked down on that swiftly, closing the loophole.

Savings star

With those early regulatory glitches safely in the rear-view mirror, the TFSA has increasingly become an attractive savings option for several segments of income-earners.

The numbers tell the tale: At the end of their first year of existence, TFSAs held a combined total of $17.4 billion in assets in close to five million accounts, according to research firm Investor Economics. Just a year and a half later, midway through 2011, the total asset amount had ballooned to $54.4 billion in 8.6 million accounts.

In other words, the average account holder has bumped up TFSA holdings by 82 per cent in just 18 months.

TFSA stats for 2011

  • Average account holding as of June 30: $6,354
  • Retail banks' share of all account assets: 65.4%
  • Proportion of that in fixed income: 83%
  • Brokerages' share of all account assets: 24.9%

(Source: Investor Economics)

In part, that's because the contribution limits keep on rising, by $5,000 a year (that amount is indexed and will start to rise by $5,500 annually in the next year or two). So in 2009 you could sock $5,000 away into a TFSA, plus an additional $5,000 in 2010, another $5,000 in 2011 and, as of Jan. 1, a further five grand.

The contribution room is cumulative. If 2012 is your first time contributing, for example, you'll have up to $20,000 in contribution room and your investments will grow tax-free within the TFSA.

That's one reason TFSAs are becoming a more attractive option for investors who do their own stock trading. A paltry $5,000 isn't much to play the markets on — you couldn't even buy 100 shares in most of the Big Six banks for that amount. But $20,000 is enough to spread around in several companies or exchange-traded funds (ETFs). 

Not surprisingly, therefore, the fraction of TFSA assets held at online and full-service brokerages has steadily risen since 2009, while the percentage held in traditional deposit accounts at retail banks has declined.

"In the beginning, the banks were capturing most of it. When TFSAs were first launched, 82 per cent of total assets was in retail banks at end of March 2009," said Sandeep Gosal, a senior analyst at Investor Economics. "Right now they're at 65 per cent. In part that's because a lot of online and full-service providers only introduced their TFSA accounts after it started."

Savers are also starting to put TFSA money into more volatile investments like mutual funds and equities, another reason that funds are increasingly going into brokerage accounts, and that funds held at banks are more and more being invested in mutual funds instead of GICs and savings accounts.

"We'd just come out of the market downturn in 2008, so you saw a lot of money going to savings accounts," Gosal said of the TFSA's early days. "People when it first launched were very risk averse."

RRSP vs TFSA

Perhaps the most stunning trend is that the TFSA is catching up to the RRSP as the tax-sheltered investment of choice.

In 2010, TFSA contributions totalled $21.8 billion compared with $33.9 billion in RRSP contributions. Last year, savers dumped $15.2 billion into TFSAs in the first six months of the year — a pace that, if it holds up, would put the two types of investments in a neck-and-neck race for Canadians' cash.

An RRSP gives a person an up-front tax deduction that they don’t get with a TFSA. But the federal government then snags its share in income tax assessed on the back-end cash withdrawals, typically after the taxpayer retires.

'The tax-free savings account is going to potentially give you a source of tax-free income, but also capital, which in my experience is always needed in the early years of retirement.' —John Kason, financial planner

As a result, it's not uncommon for financial advisers to recommend TFSAs over, or in equal partnership with, RRSPs as a savings vehicle for taxpayers.

"With RRSPs, you get a tax break now," said Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management.

"But if someone's in a low tax bracket now — I would say on average someone making under $50,000 a year — with the effect from income taxes and the clawback of government benefits they could find themselves in a higher effective tax bracket when they take the money out."

That means both the principal and the return could end up taking a big tax hit when the investment is taken out of an RRSP.

"When you withdraw the money, you lose some government benefits, which causes your effective tax rate to be higher," Golombek added. "For very low-income people, it's the GIS [guaranteed income supplement]

. For middle-income people, it's the age credit and the GST/HST credit. So it may make sense for those people to maximize a TFSA before looking at an RRSP."

John Kason, a B.C.-based certified financial planner with Global Securities, says TFSAs give people more options for what to do with their money, in part because they can withdraw it and put it back the following year — something you can't do with an RRSP. That's useful for people with lower and middle incomes, who are more likely to need access to their long-term savings if they hit fiscal adversity, or just need cash for pricey outlays like a new car or home renovations.

"I'm not a huge advocate of RRSP accounts for medium- to low-income earners," Kason says, adding that people close to retirement should also consider funding their TFSA instead of making contributions to an RRSP. "The tax-free savings account is going to potentially give you a source of tax-free income, but also capital, which in my experience is always needed in the early years of retirement."