The 2008 Federal Budget brought us a new savings vehicle concept called a Tax-Free Savings Account (TFSA), the rules of which were discussed in our Spring newsletter and appear on our website. The TFSA has a “contribution room” concept, like RRSPs. The annual room is universal for all adult Canadians and is $5,000 per annum (and subject to indexing). Thus, from a standing-start on January 1, 2009 each adult Canadian will have $5,000 of room for 2009, or $10,000 for a couple.

In part 2, we consider the ramifications and opportunities of this new scheme, and how TFSAs will fit into our existing world of sheltered accounts (RRSPs and RRIFs) and non-sheltered (taxable) accounts.

Who Can Benefit from a TFSA?

Low-income people

The genesis of this concept originally was directed at low-income people. If they could afford to save at all through their working years, they would receive low marginal tax value from making RRSP contributions. When their RRSP converted into a pension in retirement, they might find themselves precluded from various social welfare benefits otherwise available to low income pensioners. So, saving was deleterious to their financial health. The features of a TFSA remove this problem.

This problem also applies to a low income spouse in an otherwise financially comfortable couple. The low income spouse would receive little or no tax benefit from making RRSP contributions; thus, TFSA contributions may be better.

People who want a rainy day fund

One can build a savings pot which earns tax-free income to fund any unexpected expenditure.

People who wish to help their adult children

Previously, parents might have provided lump sums to assist with their children’s house acquisition, or with periodic RRSP top-up money.

In addition, or instead, now parents can help their adult children to fund their contributions to a TFSA towards life’s larger purposes, like houses, weddings, cars etc.

Couples with disparate incomes

Tax law thwarts various income splitting schemes between a couple; however, annual TFSA contributions for a spouse can be funded by the high income spouse, without attribution.

People who wish to accumulate a large education savings pool for their children

Expensive schooling may be anticipated for medical or grad school or Ivy League education. The limits of RESP accumulations may not be sufficient to prepare for this. Parents could augment in their own TFSA accounts while the children are young and could contribute to their kids’ TFSA accounts after age 18 and during the post secondary period.

Donors

The generous tax breaks on stock donations-in-kind are, obviously, irrelevant for appreciated stocks in a TFSA. Therefore, donors should endeavour to find, and donate, appreciated stocks in their regular taxable accounts. If such stocks exist in a TFSA but not in a taxable account, the stock could be sold tax-free in the TFSA and the proceeds could be donated for the tax break.

People who wish to accumulate funds for future large purchases, such as a house, car or return to school

We have had a smorgasbord of savings vehicles in the past, like RHOSPs, Home Buyers’ Plans and Lifelong Learning Plans. The TFSA may be a neat and tidy one-stop shopping vehicle for all of these purposes in the future.

People with fluctuating income

It is smart to use RRSP contributions as deductions when your marginal tax bracket is high – this increases the tax break associated with the contribution. One’s income might fluctuate for a variety of reasons, eg being in and out of the workforce, having performance-based compensation (eg a realtor) or having large one-time income like capital gains on real estate. In the past, one might make that RRSP contribution (with available cash) but defer the deduction claim until a better time. A problem with this may be that one doesn’t know when, or if, a big income year will come. But now, it may be wiser to contribute the funds to a TFSA, earn tax-free income along the way, and withdraw the funds to make an RRSP contribution when that big income year arrives. The withdrawal from the TFSA only “borrows” from your room and can be replaced another day, if you choose to.

Another opportunity exists for the charitably-minded who experience a high income year. They might draw, or borrow, from their TFSA to make a large donation to offset their high income year. That money could be paid back any time in the future, or not at all.

People who have used all of their RRSP contribution room

It is an on-going topic amongst the well-to-do that the RRSP annual limits restrict their tax-assisted savings towards their retirement lifestyle goals. Now, the extra TFSA room of $5,000 per year answers that, at least in part.

People who anticipate large estate taxes upon death

Large death taxes can arise, for instance, from deemed RRIF deregistration and from deemed capital gains on stocks, real estate and recreational properties. Traditionally, these death taxes are funded either from liquidations in the estate wind-up or from some form of life insurance. Instead, the deceased’s TFSA balance may cheaply provide such funding. Accordingly, TFSAs may cut into future insurance policy sales as a new, effective and cheaper means to fund these death taxes, as well as lower the death taxes themselves.

David RicardoPeople who wish to fine-tune their financial management by addressing tax-smart investing strategies

This area is complex and will get interesting. In economic history, David Ricardo inspired international trade by introducing his concept of “comparative advantage”. He said that, even when one trading nation was absolutely more efficient than another trading nation in producing every single good, it was still advantageous for the inferior nation to produce something, and for the two nations to trade. The more efficient nation ought to focus on the goods for which it had the highest relative, or “comparative”, advantage and leave the other goods to the inferior nation.

And so, David Ricardo leaves a legacy today for the world of tax-smart investing in the new TFSA era. From the fact that all forms of investment income are tax-free in a TFSA, it obviously has complete and absolute tax advantage over sheltered and non-sheltered accounts. However TFSAs have relatively more tax advantage with some types of income than others. Also, in infancy, TFSAs are constrained in size (and will be for a generation or more); thus forcing sheltered and non-sheltered accounts to be in the picture. Investors now will need to re-construct their sub-asset allocation strategies across all of their investment accounts to exploit TFSA’s “comparative” tax advantage. We will address this in a future edition.

Funding strategies

A working couple without a company pension plan could have as much as $40,000 in 2009 RRSP room. Starting in 2009, they also will have TFSA room of $10,000. They also may be saving in RESPs for their children at $2,500 each. This starts to add up to a lot of money – perhaps more than can be put aside in family cash flow.

If so, then some of the contributions might be funded by “switching” rather than saving. For instance, the annual TFSA contribution might be funded by transferring money, or investments, from a pre-existing non-sheltered account. The win here is the conversion of that wealth to earning tax-free, instead of taxable, income. Note that where investments are transferred to the TFSA, there will be a deemed disposition for tax purposes, and the treatment likely will be “one-way” – meaning that any accrued gains will be taxable but losses will be denied. As such, it would be wise to choose carefully which “things” you transfer.

It could be that for low income people, it might even be wise to de-register their RRSPs pre-retirement and place the funds in a TFSA. The long term gain from this strategy is to protect the entitlement to various social assistance payments after retirement.

Savings goals

For starters, it may be wise for anyone and everyone to use some of their TFSA room to finance their rainy day fund and enjoy the tax-free aspect of this new account.

Then, you should determine what your next savings goals are and how much you have saved to-date, and will save into the future.

If your goals are short or intermediate term (eg schooling, cars, housing) and your annual savings are less than your “total room”, save first in a TFSA to that limit and then in a sheltered account, at least until you have accumulated there the amounts permitted under Home Buyer rules and Lifelong Learning needs. After that, save in a non-sheltered account.

If your goals are purely long term, ie retirement, and your annual savings are less than your total room, save in a sheltered account first. Take the tax savings on the RRSP contribution and either plow back into future RRSP contributions or a TFSA.

If your goals are purely long term, i.e. retirement, and your savings are greater than your total room, save first in the TFSA and your sheltered accounts to your total room, and then in a non-sheltered account.

Beneficiary strategies

A TFSA can have a beneficiary designated at the financial institution. At this time, provincial legislation does not yet exist to recognize joint tenancy transfer on death in order to avoid including TFSAs in probate. As with other assets, a TFSA can transfer to a surviving spouse upon death and maintain its tax-free status. However, if the “estate” or any other beneficiary becomes entitled to the TFSA upon death, the subsequent income after death becomes taxable.

In the case of capital assets (e.g. stocks), these will be marked to market upon the death, and only the gains (or losses) from this value will be taxable to the beneficiary. However, a TFSA will continue to maintain its tax-exempt status until the end of the year following the year in which the TFSA account holder dies. At that point, if the TFSA is still in existence, (i.e. at the beginning of the second year following the holders death) the trust will become taxable.

Any beneficiary who receives an amount during the tax-free period in excess of the TFSA’s fair market value as of the date of the TFSA horder’s death, must include that amount in their income, with no regard to the type of income earned in the TFSA after death.

Other issues

People who are also US tax filers will find themselves in a bind because the tax-free status of TFSA investment income will not be recognized by the US IRS; therefore, U.S. taxes must be paid on this income – it is NOT tax free.

Investment management fees are directly deductible when related to Direct Trading accounts, and effectively deductible when related to sheltered accounts; however, they, and brokerage fees, will NOT be deductible for TFSA accounts.

Borrowing to make TFSA contributions will not be tax deductible.

We may see TFSAs enter the corporate world, whereby companies assist in setting up TFSAs for their employees, similar to present day Group RRSP programs

Article originally published: Oct 2008
Article revised: Jan 2009