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From an investor's point of view, are investment options that are allowed to grow 'tax free' a beneficial choice? The investor is anyway going to pay tax once he withdraws the money*.

What I am asking is: How exactly does the 'tax-free' part of a TFSA help the investor?

To be more precise, the question I am asking is: If the investor decides to cash the money at the end of the term, are TFSA and normal account investment options equivalent?


[moderator's note: for a TFSA, that premise is false.]

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Your premise is false. When you withdraw money from a Tax Free Savings Account (TFSA), there is no tax due. Yes, you can read that again: withdrawals from a TFSA are tax free. They are labeled "tax free" for a good reason! After-tax money is deposited, and then from that point forward, no tax, no tax, no tax. :-)

On a "normal", non-registered investment or savings account with no special treatment, your investment earnings will be taxed whenever gains are realized or income received (e.g. dividends or interest). You will necessarily have less in a normal non-registered investment or savings account compared to a TFSA, as long as the rate of return was positive, i.e. growing.

Perhaps you were thinking not of comparing a regular investment account to a TFSA, but rather to a Registered Retirement Savings Plan (RRSP)?

In the case of an RRSP, there is an up-front tax deduction, then earnings grow tax-deferred, and then on withdrawal, income tax is paid at regular rates. Even then, with RRSPs, if your marginal tax rate remains the same over time (not necessarily a reasonable assumption, but let's go with it) then you should still realize more after-tax income from your RRSP than from a normal non-registered investment or savings account. (Though, there's likely an exception case when most income came as qualified dividends and the capital itself hasn't appreciated.)

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Yes, they're often a beneficial choice because it means you are earning the interest on the money instead of the government.

You won't necessarily pay taxes on it, you have many options once you reach the point of wanting to do something with the money. Many people accumulate the wealth and then pass it down to subsequent generations without paying tax, which is perfectly legal if done right. Others make donations to charity.

Those are just a couple examples, but the point is that you accumulated the wealth over a long period of time and bought yourself time to decide what to do with it.

Edit: No, if the investor decides to cash the money out all at once at the end, it would not be equivalent.

Assuming you had $1,000 to put in an account and could get a 5% return on your money and you were in the 25% tax rate, the tax-free account ends up with more in the end (mostly by virtue of the compounding being tax-free):

                Taxed     Tax-Free
Year 1          $750.00 | $1,000.00
Year 2          $778.13 | $1,050.00 
Year 3          $807.30 | $1,102.50 
Year 4          $837.58 | $1,157.63 
Year 5          $868.99 | $1,215.51
Ending Amount   $868.99 | $1,215.51 
  • Your Ending Amount for the "Tax-Free" case is incorrect. It should be $1215.51. TFSA accounts in Canada do not subject withdrawals to tax. From a U.S. perspective, a TFSA is similar to a Roth IRA. – Chris W. Rea Apr 3 '11 at 11:57
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    Thanks and, sorry, I missed another issue :-) The TFSA column needs a starting balance of $750 as well. TFSA deposits come from after-tax money, again like a Roth IRA. – Chris W. Rea Apr 4 '11 at 11:52

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