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A relief valve for RRSP holders

Systems analyst Alan Whitton, shown with three-year-old son Rhys, turned to a tax-free savings account after 'maxed out' his RRSP with proceeds from a severance package.

BRIGITTE BOUVIER FOR THE GLOBE AND MAIL

TAX FREE SAVINGS ACCOUNTS

A relief valve for RRSP holders

TFSAs aren't eligible for inclusion in a registered retirement savings plan, but they can be a valuable companion tool

larry MacDonald

Canadians setting aside money for their retirement have a new tool this year: the Tax Free Savings Account program that took effect on Jan. 1.

Although TFSAs are not eligible for inclusion in a registered retirement savings plan, for many Canadians they may prove to be a valuable companion to an RRSP.

Ottawa resident Alan Whitton is a good example of how the new TFSA can be applied to retirement planning. After being laid off from Nortel Networks Corp. last summer, he "maxed out" his RRSP with his severance pay.

Now the 48-year-old systems analyst, who is between jobs, plans to stash money in a TFSA - where savings grow tax-free and there are no penalties for withdrawals.

"Given my RRSP room is now maxed out thanks to my layoff money, the TFSA will be the main area to grow extra and found money without taxes," says Mr. Whitton, a father of four.

He isn't alone in his strategy. According to a survey done for the Royal Bank of Canada last fall, 44 per cent of Canadians who planned to open a TFSA intended to use it as a vehicle for long-term savings.

Here's a look at the TFSA program, with an eye to retirement savings.

TFSA basics

A maximum of $5,000 a year can be put into a TFSA by anyone at least 18 years old. A husband and wife could each open a plan and save $10,000 a year as a family.

There are TFSAs for savings accounts, GICs, and mutual funds, as well as self-directed TFSAs that can hold a variety of assets such as cash, mutual funds, stocks and bonds.

Although contributions are not tax deductible (as with an RRSP), income earned in the account - whether from interest, dividends or capital gains - can grow tax-free. As well, contribution room accumulates and is not reduced by withdrawals, which are tax-free and can be done any time.

Register this year

Some investors may think that the $5,000 annual limit on a TFSA is too low, and not worth the hassle of opening one. But contribution room can be carried forward, and over time significant amounts can be sheltered from tax.

That's why it may be a good idea to start a TFSA sooner rather than later, even if there is little or no money to put into one.

If you're retired

If you're already retired, TFSAs can be a key financial tool. People over the age of 71 are not allowed to put money into an RRSP, but a TFSA allows them to save tax-free "for medical emergencies, custodial care and to accumulate funds destined for charities or their children," as Mercier Inc. actuary Malcolm Hamilton observes.

And people who retire before the age of 65 may find it worthwhile to withdraw RRSP money, at low tax rates, and funnel some of it back into a TFSA to have tax-free savings readily at hand.

Low-income earners

RRSP contributions are usually made when a person is in a higher income bracket than he expects to be when he retires. The tax deduction that results from the RRSP contribution often reduces a person's taxable income for that year (and may even lead to a tax refund). And when they retire, money withdrawn from the RRSP is taxed at a lower rate.

But for low-income earners, RRSPs can be a mixed blessing. "For those with limited resources, making RRSP contributions when they are approaching retirement can even have a negative effect," says Warren MacKenzie, chief executive officer of Second Opinion Investor Services Inc.

"This will be the case if withdrawing money from the RRSP will result in a reduction in the Guaranteed Income Supplement, Old Age Security payments and entitlement to other benefits, such as subsidized housing or subsidized nursing care," he explains. Withdrawals from a TFSA, however, won't involve such clawbacks.

TFSAs can also help younger people with low incomes prepare for an RRSP later on. For example, they can start off by saving money in a TFSA, tax-free, and when they move into a higher income bracket they can shift the money into an RRSP and benefit from the resulting tax deduction.

"For Canadians who have low incomes and are many years away from retirement, the TFSA is going to be their best choice since they can choose to take that money out and contribute to an RRSP when they will be in a higher tax bracket," says Preet Banerjee, senior vice-president with Pro-Financial Asset Management.

Middle-income earners

Deciding whether to put money into RRSPs, TFSAs, registered education savings plans, or paying down the mortgage and consumer debt can be less clear-cut for middle-income earners. "In most, if not all cases, the right answer is dependent on the unique circumstances of each individual," Mr. MacKenzie says. But he believes that "in all cases it is important that everyone open up a TFSA even if they make minimal or no contributions." That's because contribution room accumulates in the TFSA. So investors will "be able to contribute a large amount if they get any sudden windfall or have excess savings in the future," he says.

TFSAs can be the default choice for people who aren't sure where to put their money, Mr. Banerjee adds: "Keep in mind that the TFSA will be more flexible. . You can always change your mind and put it into the RRSP later with relative ease."

Choosing where to allocate funds is not an "either or" decision in the opinion of Gordon Pape, a long-time financial writer whose latest book is Tax-Free Savings Accounts: A Guide to TFSAs and How They Make You Rich. He recommends making use of both plans: "If cash is in short supply, make an RRSP contribution and use the tax refund to open a TFSA." Having two plans expands options when it comes to withdrawing funds.

High-income earners

As can be seen in Alan Whitton's case, the TFSA will be a boon to people who want to save more for retirement than their RRSP allows. This group includes high-income earners restricted by the contribution ceiling set at 18 per cent of earned income (a maximum of $20,000 for the 2008 tax year).

Also in this group are members of employer-sponsored pension plans, who are limited to small RRSP contributions because of the pension adjustment factor.

Fees

Some institutions, such as ING Direct, charge no fees for TFSAs, while others offer plans with a variety of fees, some of which can be rather high.

When Mr. Whitton registered for his self-directed TFSA, for example, he found out there would be an annual $50 service charge. But after learning that it is waived if the customer chooses to receive correspondence electronically, or has more than $100,000 with the institution, he signed up.

Special to The Globe and Mail

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