Don’t be fooled: TFSAs will save money

Not impressed by the debut of Tax Free Savings Account (TFSA)? You aren’t alone. In the first six months following their January 1, 2009 introduction, Canadians had opened 3.6 million TFSAs with an average balance of about $3,400, according to Investor Economics. By the end of June, total assets in the accounts stood at $12.4 billion.

Initially, some lamented the fact that individual TFSA contributions were being limited to only $5,000 a year. The TFSA was introduced just as Canada was feeling the first real bite of the worst recession we’ve faced since the Second World War, and early this year many investors were far more comfortable on the sidelines, regardless of any potential opportunities they were missing to make tax-efficient investments.

It is true that the initial account and balance totals are not insignificant, even when compared to Registered Retirement Savings Plans (RRSPs). Statistics Canada reports that the average RRSP contribution in 2007, a relatively good year for the markets and the most recent year for which figures are available, was $5,412; the median contribution was just $2,780. Certainly there are a lot more RRSP contributors — 6.3 million in 2007 — but that’s to be expected since these plans have been around for more than 50 years.

Vast potential Rather than dwelling on the early numbers (and they are not off to a bad start) financial advisors should concentrate on the potential TFSAs have to become one of the most important savings vehicles available to Canadian investors. Consider the following possibilities:

• We don’t know what final totals we’ll get for the first full year of TFSA usage and contributions, but initial reports suggest these accounts are going to become extremely popular with investors. There’s growing awareness among investors that TFSAs provide a great deal of flexibility to achieve various savings goals, so much so that these accounts may one day rival RRSPs in popularity.
• The initial $5,000 contribution may have seemed small but it’s renewed annually. On January 1, 2010, 26 million Canadians aged 18 or more will receive another $5,000 gift from the federal government in the form of additional tax-free contribution room for life. Canadian investors will be renaming New Year’s Day as “TFSA day” — a day to start sheltering more of their savings.

Talk to clients now While the business opportunity TFSAs present is a longer-term proposition, there are three good reasons why you should help your clients take advantage of this new tax savings.

First, improving economic and market conditions appear to be re-instilling some degree of confidence in investors.

Second, there’s considerable competition out there to develop this business, particularly from deposit-taking institutions that see TFSAs as another strong addition to their arsenals.

Third, the sooner you can convince your clients to open TFSAs, the more time they’ll have to grow their investment tax free, thereby maximizing tax-free returns.

A multifaceted investment The beauty of it is that there’s a wonderful story to tell clients about the versatility of TFSAs as savings tools that have benefits on their own, as well as in combination with other investment vehicles. In fact, there isn’t a client scenario that couldn’t benefit strongly from a TFSA in the context of a larger financial plan. Here are a number of ways of highlighting how TFSAs can work in tandem with other investments to help achieve different savings goals:

Everyday savings The savings goals here are near-term objectives such as a new car, a vacation or extraordinary household needs. These are the kinds of purchases people make when they have a degree of confidence in their economic prospects. Provided your clients can take advantage of the contribution room that’s available, TFSAs should be the primary savings vehicles because they allow tax-free growth and withdrawals. This makes them clearly preferable to non-registered accounts, to which clients would only contribute for savings purposes once they have used up their TFSA contribution room. Equally, because of their administrative requirements and applicable withholding taxes, RRSPs don’t have the tax savings flexibility of TFSAs and are not particularly well-suited for more general savings goals.

Buying a home Right now, low interest rates are enticing new and experienced home and recreational property buyers back to the market. A TFSA is a great place to park funds for a tactical purchase, or as a complement to an RRSP Home Buyers Plan. The HBP provides benefits similar to a TFSA because it allows investors to borrow from their RRSPs for an initial home purchase. However, HBPs are more restrictive than TFSAs because they limit borrowing to $25,000. Also, any amount borrowed from an RRSP must be repaid within 15 years.

Over time, the TFSA’s tax-free growth, straightforward tax-free withdrawal characteristics and annual growth in contribution room will make it a far more significant savings vehicle for anyone considering this kind of purchase. Until the contribution room available in TFSAs grows to more substantial proportions, most home and recreational purchases will still be funded by non-registered accounts.

Saving for an education If your clients want to save for the education of a child under the age of 18, generally the best method is to open an RESP to take advantage of the federal government’s Canadian Educational Savings Grant (CESG). Once they’ve received the maximum CESG grant, they can then invest in their own TFSAs to gain from the tax benefits, and then reinvest in their child’s RESP the following year in order to maximize the grant received.

Now that many of your clients’ adult children are back in school, you can point out another virtue of TFSAs in education planning. Once a child is 18, eligibility for the CESG ends, clients could open additional TFSAs in the child names for educational savings (and income splitting opportunities) because of their accessibility and tax advantages.

For clients planning to finance training or education for themselves or partner, Ottawa’s Lifelong Learning Plan (LLP) provides benefits similar to the HBP. Funds can be borrowed from RRSPs for LLPs on a tax and interest-free basis so long as they are repaid within 10 years. Of course, TFSAs are a natural compliment to this strategy as well.

Saving for retirement When it comes to saving for retirement, it’s not an either/or choice between an RRSP and a TFSA. It’s both. TFSAs are designed to mirror RRSPs and provide your clients with the same potential to save on taxes during their lifetimes. What is important is for clients to understand the benefits and drawbacks of both these plans and to know when to use each of them to greatest effect. As an advisor, it also helps to have a sound grasp of the client’s anticipated retirement income.

Broadly, the decision to invest in either a TFSA or an RRSP depends on an investor’s tax level at the time of contribution and at the time of withdrawal. If the investor’s marginal tax rate is higher at the time of contribution than it is likely to be when withdrawals are made in retirement, it makes more sense to invest in an RRSP, since it will defer tax payments to a point in the future when income, and consequently the individual’s marginal tax rate, will be lower. If the situation was reversed and income is likely to be higher in retirement than it is when contributions are made, then investing in a TFSA would make more sense since eventual withdrawals will be tax free. If income is likely to remain fairly consistent before and after retirement, then investing in both types can be equally beneficial.

The right plan at the right time Having made these general observations, it should also be known that one or the other of these plans can take precedence at different times in a client’s working life and retirement:

• Early in a client’s career when income and, consequently, the marginal tax rate, is likely to be lower, it will make more sense to invest in a TFSA than an RRSP;
• In the mid-career stage when income is likely to be higher, it may well be that the individual’s marginal tax rate is essentially the same as it will be in retirement. At this stage, it can work equally well to invest in either type of plan since each additional dollar will be taxed at the same rate. Of course, if there are other financial issues at this stage such as a potential need for liquidity, investing in a TFSA that permits tax-free withdrawals at any time will make more sense;
• As they reach the late stages of their careers, your clients’ earnings will likely peak and be higher than their anticipated retirement income. Given the high marginal rate the individual will have at this time, it’s advisable to invest in an RRSP in order to defer taxes. If contribution room has been used up, any excess savings can be invested in a TFSA.
• Once in retirement, your clients will normally want to put additional savings into TFSAs, provided they have the contribution room. Because TFSA withdrawals are tax free, means-tested benefits such as Old Age Security and the Guaranteed Income Supplement are not affected. But if clients continue to have high income in the early years of retirement and are age 71 and under — or have spouses age 71 and under — then RRSP contributions may be preferable so long as there is contribution room. After 71, RRSP savings are rolled into Registered Retirement Income Funds (RRIFs) and minimum withdrawals are mandatory. If your clients don’t need these funds to cover their living expenses, they can invest them in TFSAs.

Not everyone will fall into these straightforward categories, but the basic rules will hold true: early in a career when earnings and marginal tax rates are low, invest in TFSAs; as earnings and tax rates peak, invest in RRSPs; and as retirement begins, TFSAs are preferable unless income is likely to remain very high for a few years. There’s also a compromise fallback position. When your clients are younger, it’s hard to estimate retirement income so contributing to both TFSAs and RRSPs can provide a hedge against any eventuality.

Turning awareness into knowledge General awareness about TFSAs is already high, but there’s a difference between awareness and working knowledge that translates into informed decisions. That’s where the advisor can have a strong and beneficial impact on investors. You should take the earliest opportunity to help educate clients in the ways TFSAs can form an essential part of a holistic financial plan. Remind them that January 1st, in addition to marking the first day of a new year, is also when they get that renewed $5,000 gift in permanent tax-free contribution room. Over many years, those gifts can mount up.