In Tuesday's budget, the Conservatives introduced a new savings vehicle that will allow Canadians to shelter investments from tax.  Known as the Tax-Free Savings Account (TFSA), investors over the age of 18 will be able to contribute $5,000/year to a tax exempt account.

The new savings vehicle is similar to an RRSP in that investments within the account grow tax-free.  However, unlike an RRSP, investors won’t receive a tax deduction when they contribute to the account.  Instead, they won’t pay any taxes or penalties when money is withdrawn.

Not surprisingly, reaction to TFSAs (which will become available in 2009) has been positive.  As Canadians, we’re all for any solution that will help save us some taxes.  But an interesting predicament will arise for young investors that could change the face of RRSPs down the road.

Consider someone graduating from high school this year.  If they go on to university, chances are they’ll be tied up in school for four or more years, and realistically, they won’t start making any real money until they’re in their mid 20’s.  Let’s assume seven years passes (from age 18 to 25) before they’re in a position to start saving for their retirement.

They now have an option that investors from previous generations weren’t afforded: RRSP or TFSA.  Because unused contribution room carries forward in a TFSA, they could contribute up to $35,000 ($5,000 X 7 years) to a TFSA.  Conversely, they could only contribute 18% of their previous year’s income to an RRSP, up to a maximum of roughly $20,000.  Realistically, they wouldn’t be able to contribute the full amount to a TFSA, so they would continue to generate ‘carry-forward’ room.

The RRSP route has some obvious benefits (including the tax deduction), but the TFSA is a much more flexible vehicle.  Investors can withdraw money at any time without paying a penalty.  That’s a pretty attractive option to a young investor, who may have a car or home purchase or a family coming in the near future.  Furthermore, if they’re making a modest income, the RRSP deduction may be of little value.

I’m thinking that TFSAs could become the vehicle of choice for young investors.  I’m also thinking that this could pose a problem down the road.  Because these vehicles are so flexible, investors will be much more willing to withdraw money than they would be from an RRSP.  The latter creates more of a ‘forced’ savings discipline because of early withdrawal penalties.  In an era where corporate pension plans are becoming far less common and the onus on saving for retirement is placed on the individual, RRSPs are crucial.

When these twenty-something investors start to make more money and tap out their TFSA contribution limits, they may turn to RRSPs.  But they may have become too accustomed to the withdrawal flexibilities of TFSAs and opt instead for a non-registered account.

It will be interesting to see how this one plays out.