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Thursday, January 8, 2009

A Wealth of Choices: Understanding the New Tax-Free Savings Account

Finance Minister Jim Flaherty called it the only significant tax-related savings plan since Registered Retirement Savings Plans (RRSPs) were introduced in 1957.

Many economists praised it as an affordable plan that will promote savings and help bolster the economy by providing more capital to corporations. And the Canadian Taxpayers Federation called it "an excellent policy proposal."

What is it? The new Tax-Free Savings Account (TFSA) that was the focal point of Budget 2008. The new account not only can help you save, it can play significant roles in your estate and tax planning.

Starting next year, Canadians aged 18 and older will be able to invest as much as $5,000 a year in a TFSA.

The new account is the mirror image of an RRSP -- contributions are made with after-tax dollars, rather than pre-tax money, but withdrawals are tax-free.

Withdrawals will add contribution room matching the amount taken out. In contrast, when you withdraw money from your RRSP you lose contribution room. In other words, if you withdraw $4,000 from your RRSP, $4,000 of your contribution room is lost forever.

The same investments eligible for RRSPs are eligible for TFSAs. So you can hold a number of income-earning holdings in the account, including equities, bonds, mutual funds, savings accounts, and term deposits. (See Page 3 for a closer look at the benefits of TFSAs.)

However, the point of the TFSAs is not to replace registered plans. In fact, all things being equal, the two plans are a wash as the table at the bottom of the article illustrates.

There generally would be no advantage to either a TFSA or RRSP, although both can provide a better rate of return compared with unregistered savings. The only difference is that with an RRSP you receive an initial tax deduction, which leaves you with more pre-tax dollars to compound over the years. The after-tax TFSA contributions mean you essentially have less money to grow.

Ideally, you would have both accounts and maximize their uses. Then you would have the flexibility to choose annually whether to pay tax on withdrawals from a registered plan. In some years you may want to keep taxable income low to minimize benefit clawbacks and in other years you may want some taxable income to account for losses.

What all this means is that you have some planning to do with your accountant before the TFSA is introduced next year to determine how the new savings account might fit into your retirement, estate and tax strategies. Here are several possibilities to consider:

1. Shelter investment income

Generally, TFSAs will work best with fixed income investments. But if you consider yourself a very good trader, you could trade stocks within the TFSA and profits will be tax-free.

But, be wary. Capital gains inside a TFSA are tax-free, so you cannot claim a capital loss to offset other capital gains nor can you carry it forward. So if you own any laggard stocks, they would generally be wasted in a TFSA, while in a conventional investment account you can apply losses against taxable capital gains.

Generally, high-income investors with extensive investments in non-registered plans might want to keep interest-paying investments in a TFSA and stocks outside. If you have small holdings outside a registered plan, you could consolidate into a TFSA. That could save you significant tax liabilities when you withdraw the money.

It's not clear yet whether "in-kind" transfers from taxable plans to TFSAs would trigger capital gains. If such transfers were deemed a sale, you would be liable for capital gains taxes. If transfers weren't considered dispositions, you could conceivably reduce your unrealized capital gains liabilities over time.

Similar to RRSPs, there is no limit on foreign content, potentially making the accounts a good place to park foreign investments that pay dividends or interest. Under conventional non-registered accounts, foreign dividends are considered income and are taxed at the full rate. They are not eligible for the dividend tax credit. In a TFSA those dividends would be tax free.

If you happen to favour leveraged investing you can benefit by using a TFSA as collateral for low-interest investment loans. However, avoid using borrowed money to invest in a TFSA; the interest costs won't be deductible as they are in a conventional investment account.

2. Retirement planning:

You may want to melt down your RRSP as you approach 65 years of age, pay a little tax while you are in a low tax bracket, and move the proceeds into TFSAs in order to minimize future clawbacks of Old Age Security benefits.

In the year you turn 71, when you must convert your RRSP into an Registered Retirement Income Fund (RRIF) or an annuity, you could pay tax on the minimum RRIF payments and then move $5,000 of the remaining money into your TFSA each year, sheltering that income from taxes for the remainder of your life. The advantage here is maintaining tax-sheltered savings for emergencies or estate planning.

TFSAs could also supplement RRSPs if you have maxed out your contribution room and still want to continue putting aside money for later years.

3. Estate planning:

TFSAs will make it easy to bequeath large tax-free nest eggs. The amounts could total $1 million or more over 40 years of savings. TFSA holders can name spouses or common-law partners as beneficiaries and rollover the proceeds tax-free to them upon their death.

Money in RRSPs or RRIFs is taxable on your final income tax return.

4. Income splitting:

As with spousal RRSPs, spouses or common-law partners can contribute to their partner's TFSA. And when it comes to income splitting for taxes, attribution rules will not apply to income earned in a TFSA.

5. Pension plans:

Some specialists suggest that low-income earners may choose TFSAs instead of employer-sponsored pension plans because the latter will generate taxes in retirement, while the former will not.

The Fundamental Implication: TFSAs offer you an additional choice on how to manage your savings and investments. Consult with your accountant for the best ways to use this new account to maximize your wealth.

Net Proceeds from Saving in a TFSA Relative to Other Types of Savings

TFSA RRSP Unregistered Accounts
Pretax income ($) 1,000 1,000 1,000
Tax owing ($) 400 -- 400
Net contribution ($) 600 1,000 600
Investment income*($) 1151 1918 707**
Net contribution plus Investment income ($) 1,751 2,918 1,307
Tax*** ($) -- 1,167 --
Net Proceeds ($) 3850 $782 1
Tax*** ($) 1,751 1,751 1,307
Net annual after-tax Rate of return 5.5% 5.5% 4.0%
* Twenty years at 5.5 per cent.
** Tax rate on investment income is 28 per cent, representing a weighted average tax rate on an investment portfolio comprised of 30 per cent dividends, 30 per cent capital gains and 40 per cent interest.
*** Forty per cent rate

Benefits and Drawbacks In a Nutshell

The Tax-Free Savings account is available to anyone 18 years of age or older. And for that reason, some specialists recommend that anyone turning 18 this year should file a tax return regardless of how much income they earned in order to start qualifying for the annual accumulation of $5,000 TFSA contribution room.

There are many benefits to owning a TFSA, including:
  1. Tax-free compounded growth and withdrawals. Contributions are made with after-tax money.

  2. Withdrawals won't affect income-tested benefits such as the child tax benefit, GST credit, age credit, or Old Age Security payments or supplements;

  3. No upper age or lifetime limit for contributions. If you don't contribute for 25 years and then receive a $100,000 inheritance, you could conceivably shield that entire amount from taxes.

  4. Unused contribution room is carried forward indefinitely and withdrawals can be replaced later without penalty or having to create additional contribution room. Unlike an RRSP, withdrawals will be added back to accrued contribution room. So, if you don't use your $5,000 contribution room for five years, your accumulated room will build up to $25,000. If you contributed the maximum in the first year and withdrew $1,000 in the fifth year, your contribution room in the sixth year would total $26,000 ($5,000 times six minus $5,000 plus $1,000).

  5. You don't need earnings to make annual contributions.

The accounts also present some drawbacks that should be considered:
  1. Interest paid to borrow money to contribute to a TFSA isn't tax deductible;

  2. Over-contributions are subject to a penalty of one per cent a month, the same as RRSPs, and

  3. Capital gains (or losses) accrued in a TFSA won't be available to offset gains/losses outside it. Contribution limits will be calculated on the annual Notice of Assessment you receive from Canada Revenue Agency (CRA).

Bennett Gold LLP, Chartered Accountants

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