Still More on Tax Free Savings

I’ve posted below some interesting comments from Richard Shillington, a senior associate at Informetrica Ltd – who among many other accomplishments has drawn attention to very high effective tax rates on low income Canadians, and the failure of many programs to reflect the realities of life in low income.  I think Richard advances a good alternative solution to a real problem addressed by tax free savings accounts.

“As some of you know I’ve been pushing for some form of relief for the millions of Canadians who retire without an occupational pension and end up with a median income of about $15,000.  If this weren’t bad enough the design of GIS makes it near impossible for them to improve on this by earnings or by RRSP withdrawal – even their CPP was subject to a 50% on top of which the income is still taxable (many won’t pay income tax but some will). Put this person in social housing where their rent is 30% of income and their “Effective Marginal Tax Rate” is now 100%.

About half of Canadians retire with no occupational pension. The majority of those who retire without an occupational pension are eligible for GIS. About 80% of RRSP assets are held by those with an occupational pension.

I recall that about half of those who retire with no occupational pension have some RRSP – the average amount is $30,000-$40,000. Given their modest incomes many people sacrificed in order to accumulate this small RRSP.

Many low and modest income Canadians do they just don’t save much. Yet the GIS rules ensure that any RRSP them virtually no good. Indeed, because of GIS clawback, CPP for many lower-income Canadians is not such a hot investment; it becomes a mutual fund with a 50% back-end load.


My preferred option is to expand the GIS earnings exclusion to other forms of income. GIS should ignore about $4,000-$5,000 of earnings but also other income – like CPP and RRSP withdrawals. This allows all Canadians to save in an RRSP without them having to guess whether they are “GIS destined” or not. Lower-income Canadians will not save much and will know that, at retirement, if they just keep their RRSP withdrawals below some modest amount ($3,500) it will not affect their GIS. This would also make CPP a much better deal for them.

The $3,500 earnings exemption in the budget is a great step but doesn’t go far enough to be remedy because it is only for earnings. This remedy would have been much cheaper to the government than this TFSA.

This TFSA with the annual $5,000 of room helps my “futile savers” but has it’s problems. First, Canadians without an occupational pension will still have to decide if they should use an RRSP or TFSA. The banks and insititutions don’t sell good advice, they sell mutual funds. The TFSA’s don’t simplify retirement planning for those without a pension plan. We will need to develop financial advice tools for lower-income Canadians to help them navigate the RRSP/TFSA decision.

I also think that, in the long run, the TFSAs are HUGE for a few very high income Canadians. The accumulating $5,000 annual contribution limits are indexed (albeit awkwardly). At 48 you have a limit, in constant dollars, of $150,000 per person in a couple.

So I would modify the TFSA  to limit the life-time contributions to a more modest amount, say $50,000. This will help my futile savers while limiting the wind-fall to the wealthy.

Remember, that in the short term these TFSA’s are not a windfall for the wealthy and will help many low and modest income Canadians. The unaccpetable windfall only happens over the long-term. We have 10 years during which one could create a life-time limit which is acceptable. 

Bottom Line…  

The TFSA is a remedy for my ‘futile savers’ but not my first choice.

As proposed, it’s better than the status quo (some will disagree we’re weighting trade-offs). But in the long run, it is very generous to a few higher income Canadians but we can fix that later.

So… one could advocate for a broader GIS exemption instead (good luck on this, this TFSA is out of the bag and will be popular. I would suggest advocating for limits to the ‘open ended nature’ of the TFS, keeping its value for modest and lower income Canadians – many of whom do save in small amounts, but impose a life-time limit – say $50,000.

This would also be a great opportunity to advocate for a $5,000 reduction in RRSP limits.

One comment

  • I had the following comment in today’s (March 4th 2008) Toronto Star. I was restricted to 500 words. Finn Poschman wrote the ‘pro’ comment. Finn’s comment was all about the poor low income saver who would otherwise get his or her GIS penalized. According to Finn we have to hand over multi-billion dollar tax breaks to the wealthy in order to provide a few hundred dollars benefits to the poor, but thems the (tax) breaks, I suppose.

    Flaherty’s tax-saving plan: CON – comment – Flaherty’s tax-saving plan: CON

    Gives advantage to high-income families

    March 04, 2008
    Michael Mendelson

    In the 2006 election campaign the Conservatives promised to “eliminate capital gains tax on the sale of assets when the proceeds are reinvested within six months.” This promise made some sense. It would neutralize tax considerations for many reinvestment decisions while ensuring tax would eventually be paid when capital gains are used as income.

    Instead, in his 2008 budget Finance Minister Jim Flaherty introduced “tax-free savings accounts” – from age 18 anyone can save up to $5,000 a year (indexed to inflation) in a TFSA. Income in TFSAs will be permanently exempt from all taxes.

    On the surface, TFSAs may look like a similar but more modest version of the promised capital gains exemption. Nothing could be further from the truth. The original promise would have deferred tax on capital gains, not eliminated it. Furthermore, investors would have paid tax on dividend and interest income. In contrast, income from TFSAs is exempt from all taxes – forever.

    Nor are TFSAs a minor adjustment in Canada’s tax system. For example, if a couple maximizes contributions to a TFSA for 20 years and earns 5 per cent a year, they will accumulate a non-taxable fund of $330,000, even with no inflation. Untaxed investment income would exceed $7,600 a year. If a family contributes $5,000 each year to an 18-year-old child’s TFSA and keeps making those contributions, at age 65 the TFSA will be almost $900,000, with untaxed annual income of $42,000. Add inflation or higher investment returns and TFSAs become humongous: assuming 2 per cent inflation and 7 per cent returns, a couple contributing for 40 years would have a TFSA of $2.5 million.

    There is nothing modest here. As the scheme matures, almost all investment income will find its way into TFSAs. Over time the TFSAs will give a tax-free pass to most investment income in Canada. Within a few decades the loss of revenue for Ottawa will likely be far more than the $3 billion estimated in the budget – plus about half as much again in lost provincial tax revenue.

    If you think these revenue losses will not affect you, think again. This is a major tax shift, more or less eliminating taxes on investment income while radically increasing the proportion of tax revenue from earned income.

    And this tax shift will be astonishingly unfair. According to 2005 data from the Canada Revenue Agency, the 4 per cent of tax filers with incomes over $100,000 had 67 per cent of total taxable capital gains. Upper-income families will be able to use all the contribution room available, shovelling $5,000 into a TFSA every year for each eligible family member. Middle-income families will be able to use only a fraction of their TFSA room. Most lower-income families will have no TFSA savings at all. TFSAs will add substantially to growing inequality as rich families assemble enormous funds paying them tax-free income, while most average-income families continue to trudge along on fully taxable employment income.

    The TFSA is a ticking time bomb in Canada’s tax system: it is both unaffordable and unfair.

    Michael Mendelson is a senior scholar at the Caledon Institute of Social Policy.

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