Since 2009, about five million Canadians have opened up tax-free savings accounts. (iStock)Many two-year-old children experience behavioural problems, things like not doing as they are told.

Well, it turns out so does Canada's two-year-old tax-free savings account (TFSA) — the Harper government's main innovation to encourage Canadians to put away more cash for retirement.

From a standing-start in January 2009, about five million Canadians have now opened these specialized savings accounts to the tune of $19 billion in cash and other assets.

Most of that cash is unlikely to have been squirrelled away without the added incentive of a TFSA.

Popularity's seedy side

But, as acceptance of the new account has mushroomed, so has schemes designed to take illegal advantage of the tax breaks.

Pumping these accounts full of penny stocks that explode in value and other game playing has allowed some investors to supercharge their tax savings by shady means.

In early 2010, the federal Department of Finance brought in measures to tighten up loopholes and dampen down this type of crafty activity.

"We want to ensure that the rules work appropriately for everyone," said Finance Minister Jim Flaherty in announcing draft legislation to limit the inappropriate use of TFSAs to shelter other income.

The new rules include the taxing of earnings accumulated in a TFSA as the result of an over-contribution.

Savings star

Still, for Canadians with sufficient cash, opening up a TFSA might even be better than working through a registered retirement savings plan (RRSP).

"An RRSP is primarily for retirement. The TFSA is like an RRSP for everything else," said Adrian Mastracci, portfolio manager at KCM Wealth Management based in

'The policy idea was to force or incent Canadians to save more.'—Kim Moody, tax expert

Vancouver.

The TFSA was born out of Ottawa's worry that Canadians were spending all their available cash and not putting enough funds away to ensure their so-called golden years did not turn to brass.

"The policy idea was to force or incent Canadians to save more," said Kim Moody, an expert in tax and estate planning with Moody's Tax Advisers based in Calgary.

TFSA vs. RRSP

Under federal rules, Canadians could dump as much as $5,000 annually in whatever form they desired — stocks, bonds, cash or guaranteed investment certificates — into their TFSA accounts.

Ottawa still snags its tax share on the contributions but allows people to accumulate investment income within the account and to withdraw the resulting proceeds on a tax-free basis.

The RRSP is a better savings vehicle for peak earners who then enter a lower tax bracket as they retire. (iStock)By contrast, an RRSP gives a person an up-front tax deduction. But, the federal government assesses its levy on the back-end cash withdrawals.

As a result, the TFSA has turned out to be particularly popular among wealthier Canadians, people who had already maxed out their RRSP contributions and could use the tax-free savings vehicle to protect more cash from the taxman.

That is because a person using a TFSA can take out more cash compared to an RRSP if that taxpayer faces a higher marginal tax rate when he or she withdraws the money versus when they contribute the cash.

Back in 2009, Sherry Cooper, chief economist with BMO Economics, gave the example of $1,000 going into a TFSA compared to the same money placed in an RRSP.

With a back-end tax rate of 46 per cent, the person with the tax-free account could pull out $1,857 compared to the RRSP holder who could only withdraw $1,433, she calculated.

"For those people, especially higher income earners, who have extra funds after reaching their RRSP contribution limit, it offers an attractive way to reduce taxes on income-bearing assets and capital gains. TFSA customers tend to be older and more affluent, not surprisingly," Cooper wrote.

By contrast, the RRSP is a better savings vehicle for peak earners who then enter a lower tax bracket as they retire.

Happy politicians

So, the TFSA has faced some teething problems.

But, all in all, Ottawa is pretty pleased with its tax-saving instrument.

"[It] is the single most important savings vehicle for Canadians since the launch of the RRSP," said Flaherty in a December 2010 press release reminding Canadians of the $5,000 annual limit.

And, as more and more Canadians save valuable tax dollars through their TFSA, they would probably agree.