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That’s the “fantastic” interest rate I could get two years from now if I invest in a “3-Year RateBuilder” RRSP…

By Amelia Bellamy-Royds , in The Numbers Game , on February 2, 2009

That’s the “fantastic” interest rate I could get two years from now if I invest in a “3-Year RateBuilder” RRSP with my credit union.

It’s an eye-catching number, if you’ve been doing some rate comparisons lately.  No one else is offering even 4.5% guaranteed interest on term deposits.

So what’s the catch?  Well, the catch is to get that great interest rate on the third year of the term, you have to accept merely okay interest rates (1.75% and 2.45%) in years one and two.  If you do the math, the net income works out as slightly less than a 3.55% rate over three years:

1.0175 * 1.0245 * 1.0650 = 1.11019
1.0355 * 1.0355 * 1.0355 = 1.11032

Now, 3.55% on a three-year term is a pretty good rate these days.  But it isn’t exactly headline-worthy.  A month ago, I could have got a 3.75% rate on a three-year term at the same institution.  Last year, I could have got 4% over four years if I hadn’t greedily put my money into a one-year term at 4.5%.

Now, I can’t really blame myself for not predicting the collapse of the international banking system.  Nor can I blame my bank for wanting to put eye-catching numbers on their advertisements.  It’s just a little reminder, to myself and anyone else, to get out your calculator before getting out your wallet.

You might also want to get out your calculator before you go out to vote, too.  If you’re checking out RRSP rates this month, you’ll inevitably also run into something called a TFSA: a Tax-Free Savings Account.  This was a big announcement in last year’s federal budget, back when times were good and the government wanted to encourage people to save money instead of making it easy to borrow it.

The Tax-Free Savings Account is all about eye-catching numbers that pale on closer examination.  Under this program adult Canadian residents can deposit up to $5000 per year in a designated account and not pay tax on any interest income.  Unlike an RRSP, the TFSA is aimed for shorter-term savings: for a new car, a new house, or a return to school.  Also unlike an RRSP, you don’t defer taxes on the money you contribute: neither contributions nor withdrawals affect your taxable income.

Five thousand dollars tax free.  Sounds great, doesn’t it?  But you’re not avoiding taxes on $5000 – you’re avoiding taxes on the interest on $5000.  Assuming a (currently generous) interest rate of 4%, that means you’re avoiding the taxes on $200.  If you’ve got a relatively low income (less than $38,000 per year), the tax you would have paid is 15% of this amount – i.e., $30.  That’s my first problem with the TFSA – false advertising.  It sounds great to say $5000, but it works out as at most $30 extra in your pocket.

But that’s if you’ve got a relatively low income.  In contrast, if you’re in the highest tax bracket, the tax you’re avoiding is 29% of the extra income – i.e., $58.

That’s my second complaint about the TFSA.  Any tax scheme whereby two people can do the exact same thing but the wealthier one gets nearly twice the tax break just doesn’t seem right.

And, of course, the discrepancy only gets worse when you consider that the effect is cumulative.  Next year, our two hypothetical citizens could be avoiding taxes on the interest on $10,200.  The year after (assuming a constant 4% interest rate, compounded annually), it would be $15,608.

That also assumes, of course, that the low-income person could afford to find $5000 at the beginning of each year to put aside.  More likely, such a person would only be using the account temporarily, before withdrawing the money to pay for whatever they have been saving up to buy.

But the cumulative effect doesn’t just affect an individual’s finances.  It also changes the impact on the federal treasury.  In the 2008 Budget, it was estimated that the lost tax revenue would grow from $50 million in 2009-10 to $385 million in 2012-13.  That’s good if you think the government collects too much tax, not so good when you think that the government is currently predicting a deficit from now until 2012-13.

So those are my three strikes against the TFSA:  it’s a heck of a lot of paperwork for a small amount of return, the return you do get is better the wealthier you are, and it has a progressively greater impact on the budget each year (with the progressively larger benefit going to those who can afford to put money aside without touching it).

But $30 bucks is still $30 bucks, and I do have money in the bank, saved up to pay for going back to school, which could temporarily be moved to a tax-free account.  So in addition to rate comparing on RRSPs, I’ll also be scouting out the best TFSAs this month. But I’ve been procrastinating about it, ’cause I’m uncomfortable endorsing such a problematic tax policy.

Well, that and I’ve just been hoping to find a great interest rate that isn’t too good to be true.