January 2009

The TFSA is here!

Ever since the creation of the TFSA was announced in the 2008 federal budget, everyone’s been talking about it.  Now, it’s a reality…  The TFSA is in effect.  And ignoring it would be a mistake! 

The Tax-Free Savings Account (TFSA) will change a great many things in the way Canadians manage their savings and their investments in the future. Besides providing them with a new tool to protect their investment returns from the taxman, it will also cast a new light on the tools they are already using, in particular RRSPs, RRIFs and RESPs.

$5,000 a year … and more

The TFSA is an account in which any Canadian adult can deposit up to $5,000 a year. This $5,000 contribution limit is cumulative, that is, if you don’t use the entire amount in a given year, the unused portion is carried over and added to the $5,000 contribution limit for the following year. Moreover, this limit is indexed to inflation, which means that the $5,000 contribution limit will eventually become $5,500, then $6,000 and so on. As well, unlike the RRSP, the TFSA is not linked to your earned income and has no time limits: any Canadian can deposit $5,000 a year for as long as he or she likes. After a number of years, the accumulated capital can grow to be substantial.

Even better, with a TFSA, both your returns (interest, capital gains, etc.) and withdrawals are completely – truly – completely tax-free.

Truly free of taxes

The simplest way of properly understanding the TFSA is to compare it to an RRSP or a RESP. These two plans are also designed to grow your savings and shelter them from taxes over many years. They are both excellent savings tools. What’s more, RRSP contributions are tax deductible, and RESP contributions are entitled to generous government grants.

But remember, the tax authorities are waiting just around the corner: when you withdraw
your money, it becomes entirely taxable, which makes these tax-deferred plans.
If your marginal tax rate is lower when you withdraw your money than when you made your contribution or when your money grew, you’ll end up with more after-tax money in your pocket.  But, if it’s not…

On the other hand, TFSA withdrawals are completely tax-exempt, which makes the TFSA truly tax-free.  Fact is, the income taxes are paid by the taxpayer before the TFSA contribution is made. Then, for whatever time the money remains in the TFSA, it is not taxable. More importantly, neither are the returns it generates.

So many possibilities
It takes just a little imagination to see how, because of this very feature, the TFSA can easily be integrated into a sound financial strategy.

  • Increasing capital available at retirement

If you can’t contribute as much as you would like to your RRSP because of regulatory limits or your pension adjustment, the TFSA provides you with a brand new, tax-sheltered savings option. Don’t forget that:

    • TFSA withdrawals are not taxable at retirement;
    • You can withdraw your money whenever you like (there’s no need to transfer it to a RRIF or make withdrawals every year);
    • And these withdrawals are not considered as income, which means they will not affect your payments from means-tested programs like Old Age Security.
  • Retirement income splitting
    Spousal RRSPs and splitting rules for retirement income already exist.  But the TFSA provides an additional way of splitting income to lower a retired couple’s income taxes. Also note that the TFSA is not subject to attribution rules.
  • Saving to buy a home
    Many young couples use the Home Buyers’ Plan (HBP) to help finance their first home.  The HBP allows you to borrow from your RRSP to purchase a home, and then reimburse the plan over a period of 15 years. Now, the TFSA can also be used to build up such valuable capital. It’s true that TFSA contributions are not tax deductible, but withdrawals don’t ever have to be reimbursed. Moreover, the TFSA is not limited to the purchase a first home only: it can also be used for a second home, a third one – and even to make renovations..
  • Financing education
    To save money, tax-free, for the post-secondary education of your children or grandchildren, nothing beats the Registered Education Savings Plan (RESP), which benefits from generous government grants. Depending on the province, such grants can amount up to 30% of invested capital. But, now, you can contribute just enough to your RESP to entitle you to the maximum grants, then put any additional funds into a TFSA to save for your children’s education. These savings are not subject to an RESP’s restrictive rules and their use is more flexible.
  • Creating a contingency fund
    Everyone should have savings equal to at least three months of income in case they lose their job. The TFSA is the very best account in which to put such savings since generated returns are tax-free, as are all withdrawals.
  • Protecting your investment gains
    All profits in a TFSA are tax-exempt. For example, if the value of one of your investments increases from $5,000 to $10,000 in a few years, you can cash in your $5,000 gain without paying any income taxes. Better still, if you withdraw your money, your contribution limit for the next year is increased by the amount of your withdrawal. This doesn’t mean you should use the TFSA to play the stock market … but it is an interesting vehicle for investments with potentially high gains. Don’t forget that, just like an RRSP, a TFSA can include a variety of investment instruments.

In addition to the above, the TFSA can be used for any project for which you would want to put money aside:  a major purchase (car, TV, computer, etc.), a course, trip, gift … 

In fact, the TFSA is best way of sheltering your projects from taxes.