Perhaps not since the hula hoop, pet rocks and the latest Indiana Jones movie has something caused such buzz on Main Street. Everyone is talking about the new tax-free savings accounts (“TFSA”) created by this Budget. Have Finance Minister Flaherty and the minority Conservatives executed a political coup de tax in time for an upcoming election call?
Starting in 2009, resident individuals at least age 18 may establish one or more TFSAs through Canadian financial institutions. Similar to RRSPs, new contribution room accumulates annually but is not tied to generating “earned” income. The annual limit starts at $5,000 and is scheduled to be indexed in the future. You may have contributed up to your accumulated room at any time in your life. Excess contributions are subject to a 1% penalty, as with RRSPs.
Like RESPs, and unlike RRSPs, the capital contribution does not generate a tax break, nor is the withdrawal of capital taxed. Unlike either of them — and here’s the excitement — the accumulating investment income that the account earns is also not taxed upon withdrawal.
Aside from this generous tax treatment, the investment rules of TFSAs generally will be the same as those that govern RRSPs, including the point that borrowing to contribute does not create deductible interest. Unlike RRSPs, however, the assets in a TFSA can serve as collateral for borrowing.
Unlike RESPs (and special purpose education and home-buying in RRSPs), TFSA funds can be withdrawn for absolutely any purpose in life.
Unlike RRSPs and RESPs, you may withdraw funds from the TFSA and replace them later. In effect, then, your accumulating room is a life-time amount that can be held in the account.
Existing attribution rules between spouses are irrelevant because TFSAs are tax-free; therefore, one spouse can fund the other’s TFSA contributions.
The tax treatment of TFSAs upon death will parallel RRSPs. The account can transfer directly as a named beneficiary, or indirectly through the will, to a surviving spouse and retain the tax-free character. Otherwise, the income earned in the account after death becomes taxable upon death.
Again, like RRSPs, TFSAs can be transferred in marital breakup.
Unlike RRSPs and RESPs, there are no age implications to TFSAs (other than age 18). An interesting twist is that individuals who cease Canadian residency may maintain their TFSAs and continue to earn income free of Canadian tax. No contributions may be made, however, and no annual new room will accrue. There may be tax issues, however, in the new country of residence.
The tax-exempt nature of investment income in a TFSA merits some thought and strategizing. This same analysis has long been forged between sheltered and non-sheltered accounts and historically provided some useful guidelines. With TFSAs, there is now a third type of account to consider, and the analysis starts anew. For starters, interest income would be the most favourably treated in a TFSA as compared to the other two accounts. Capital gains would be better off, also, in a TFSA as zero, as opposed to half or all, of a gain is taxable. Eligible dividends are already well treated in non-sheltered accounts for middle income investors, but those tax credits are foregone in both TFSAs and sheltered accounts. Foreign dividends will continue to attract foreign tax in TFSAs and non-sheltered accounts and not in sheltered accounts. These credits will not be usable in TFSAs.