Ten things to know about TFSAs

The nuts and bolts of these new tax-sheltered accounts -- and who benefits most from them

By Dianne Maley
Globe Investor Magazine online, Jan. 6, 2009



Every year about this time, people's thoughts turn to the same nagging question. Should I pay down the mortgage or contribute to an RRSP?

This year there's a new claim on your savings, the tax-free savings account or TFSA. Starting Jan. 1, Canadians aged 18 and older can contribute up to $5,000 a year to an account in which income - whether from interest, dividends or capital gains - can grow tax-free. TFSAs are being lauded by financial institutions, and some financial advisers, as the most important tax break since RRSPs, regardless of your age or circumstances.

Others are more reserved in their assessment. "I'm pop-eyed by the hype," says Warren Baldwin, regional vice president of T.E. Wealth in Toronto, who figures the potential savings don't merit all the attention. "The amount is so small in the grand scheme of things." Still, anything that might save taxes is worth a look. Here are 10 things you should know about TFSAs.

What is eligible
Pretty much anything you can put in an RRSP, you can also put in a TFSA - cash, guaranteed investment certificates, term deposits, mutual funds, income trust units, REIT units, stocks and bonds. However, stocks and stock mutual funds might be better held in a non-registered account because capital losses cannot be used to offset capital gains in a TFSA.

How much you can contribute
Each person is allowed to contribute $5,000 a year indefinitely, regardless of age, $10,000 a year for a couple. This is much less than for RRSPs, where contributions are 18 per cent of earned income to a maximum of $20,000 for 2008. The government will keep track of your contributions and withdrawals when you file your income tax form each year, indicating the amount of unused TFSA room. Unused contribution room can be carried forward indefinitely.

If you contribute more than the allowable amount in a year, you will pay a penalty of 1 per cent a month on the excess contributions.

What you can use them for
Anything you want. You can save for a house, buy a car, start a business - even take a trip. Best of all, when you withdraw money to spend, the government adds that amount to your next year's contribution room.

Tax treatment
Contributions to TFSAs are not deductible from taxable income so there is no upfront tax break. The break comes later, when you cash them in tax-free. In the meantime, money earned on your contributions, whether interest, dividends or capital gains, can grow tax-free.

Retired people stand to gain
With TFSAs, there is no point in time at which you have to stop contributing and start withdrawing.

TFSAs help shield retired people with modest savings from having government benefits such as the Old Age Supplement or the Guaranteed Income Supplement clawed back because of RRIF withdrawals or annuity income.

Low-income Canadians have been discouraged from investing in RRSPs because they might get 25 per cent back in taxes when they contribute only to end up losing 75 per cent of their public pension benefits to the clawback.

Neither income earned in a TFSA nor money withdrawn will affect a person's eligibility for federal income-tested benefits and credits, including the age credit and the child tax credit.

As well, retired people, depending on their tax bracket and other circumstances, may be able to save taxes on income earned by shifting some money from other investment accounts, such as registered retirement income funds or RRIFs, to TFSAs.

People who do so still will have to pay taxes on RRIF withdrawals, but they will be able to put the money withdrawn into a TFSA, where future investment income will be housed free of tax even when it is withdrawn.

Income splitting
TFSAs can help couples and families lower their tax bill through income splitting because a higher income spouse can contribute to a TFSA for a lower income or stay at home spouse without the income being attributed back to the higher income taxpayer. As well, TFSA assets can be transferred to a spouse upon death, although the details of this are still being worked out.

Borrowing to invest
If you borrow to invest in a TFSA, the interest on the loan will not be tax deductible. Unlike RRSPs, though, the assets in a TFSA can be used as security for a loan. Rather than borrowing, advisers suggest contributing to an RRSP and depositing your tax refund in a TFSA.

Where you can get them
At banks, trust companies, credit unions and investment dealers. Discount broker Questrade, for example, offers what it calls a tax-free trading account, with no fee and a $1,000 minimum.

How much you stand to save
Very little, Mr. Baldwin says, especially if you opt for the savings account-type TFSAs many financial institutions are offering. At the 2 per cent or so a savings account pays, you will earn $100 on your $5,000 deposit, he notes. At the top marginal tax bracket, you will save $46. "That's minuscule."

Remember, too, that most financial institutions will charge an administration fee, which will eat into your returns.

What they're good for
TFSAs are certainly better than RRSPs for a rainy day fund because you can withdraw the money tax free in an emergency. In a year or two, though, you will probably have all the emergency money you need.

For younger people with a long time horizon, TFSAs may be a good complement to RRSPs because they are another way of sheltering income - provided the money is invested in a balanced portfolio and not left to languish in a low-yielding savings account. And they may benefit retired people by helping them avoid the clawback of their pension benefits. The key is how they fit in with your financial plan.

"They require some thinking," Mr. Baldwin cautions. "Our fundamental position is they have to be properly structured as part of a portfolio. They have to be integrated into an overall financial plan."

Special to the Globe and Mail