WEALTH Matters — WINTER 2008

Tax Free Savings Account (TFSA)

The 2008 Federal Budget introduced the first new tax shelter in many years: the Tax-Free Savings Account (TFSA).

Many GIC issuers and mutual fund companies are offering TFSA status on various investment products, and the media has been full of advertising for these products.

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Making lemonade

tax-loss selling

Asset swap

Tax free savings account

The immediate benefit is fairly obvious – earnings in a TFSA are not taxable. This could almost double your net return on interest income which is otherwise fully taxable at up to 46% income tax rates. What might not be so obvious are the financial planning opportunities and pitfalls of this new tool.

Each individual age 18 and over can deposit up to $5000 in 2009 (joint accounts are not allowed). At this point the savings are not large dollar amounts: if you earn 5% interest on $5000 this is only $250 and the tax you’ll save is a maximum of $115 per year. But in the future, the savings will multiply because you will gain $5000 contribution room per year and no maximum has been specified. If you have open investments, you should use the TFSA. Although deposits are not tax-deductible as with an RRSP, you can withdraw your principal and interest without paying any tax, and can re-contribute the withdrawn amount in a future year.

One of the pitfalls to watch out for is holding equities in a TFSA when you have fixed income investments that are not in a RRSP or TFSA. The article on Asset Swaps in this issue of Wealth Matters explains why this is not as efficient as holding the equities in an open account and the fixed income in the tax shelter. (Click here to read the Asset Swaps article.)

One of the largest opportunities in the TFSA is for retirees who have significant RRSP, RRIF, or LIF balances and are taking the minimum payment. This is an estate-planning time bomb and the TFSA can help defuse it.

On the death of the last surviving spouse, any amounts remaining in a registered plan such as a RRIF become fully taxable as income in the year of death. Even a modest $50,000 RRIF balance when added on to an average income can push the deceased taxpayer into a much higher tax bracket than when they were living.

A more efficient strategy is to exhaust the RRIF during lifetime at lower tax rates, and move the excess income into the TFSA where it can still grow tax free, and will not be added to income at death.

This strategy is particularly effective for retirees who have low non-registered assets but significant RRIFs, and who may require cash from time to time for a new car, or to replace their roof or furnace. These lump sum expenses may require a large RRIF withdrawal which can push them into a higher tax bracket and even reduce their Old Age Pension the next year. Better to draw a little extra RRIF income each year and accumulate a TFSA balance for when the larger expenses arise.

A good strategy for employees or business owners is to use the TFSA instead of an RRSP contribution in both very high earning years and very low earning years. In high earning years when the RRSP deduction limit would be exceeded, put the excess in the TFSA to shelter the investment earnings, and move it to the RRSP when more contribution room has accumulated. In a low earning year, you may be in a lower tax bracket and the RRSP contribution might be worth much more to claim in a later year – the TFSA can shelter the investment income while not committing you to the RRSP in case you later need the money after all. If your income later grows and puts you back in the higher tax bracket, then move the TFSA money to the RRSP and claim your deduction.

We will show you how the TFSA fits with your situation when we next review your portfolio.

Also in this issue of Wealth matters:

Making lemonade

tax-loss selling

Asset swap

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