Maximizing the TFSA

In 2009 Canada finally caught up with many of the OECD (Organization for Economic Co-operation and Development) countries’ use of tax-preferred accounts to stimulate domestic savings.

The U.S. introduced the Roth Individual Savings Plan (Roth IRA) in 1997 and the U.K. debuted the Individual Savings Plan (ISA) in 1998—the product that’s most similar to our TFSA. Since its inception the TFSA has been seen as a little savings darling, but over the longer term it can have broader financial planning applications.

With job security still a large concern for most Canadians, the TFSA could not have come at a better time. According to the January 2010 RBC Canadian Consumer Outlook Index, one in four (26%) Canadians are worried about losing their jobs—an increase from 21% in December. Meanwhile, unemployment is still relatively high at 8.3% in January, and most of the gains in employment continue to be in part-time jobs.

The flexibility of the TFSA gives people who face employment uncertainties an effective financial planning tool to navigate through tough times. Funds that accumulate in a TFSA can act as a contingency fund, and later as a means to reduce income taxes.

When the employment situation improves and people are at a higher marginal tax rate relative to the rate they were upon losing their job or seeing an income reduction, they could transfer a portion of the unused contingency money tucked away in their TFSA into the RRSP. By coordinating the use of a TFSA with an RRSP to changes in the individual’s marginal tax rate, larger tax savings can be realized in the future.

Also, at a lower marginal tax rate relative to when they contributed to their RRSPs, and if their retirement incomes are expected to be higher as a result of government benefits, this may be a good time to harvest money out of RRSP and into the TFSA.

Doug Carroll, vice-president of tax and estate at Invesco Trimark, says if individuals use this strategy, it’s important they realize it means they’ve gotten rid of some of their RRSP holdings and that they should not inadvertently use that money “to buy a power boat.”

The key to coordinating the use of TFSA with RRSP, he says, is to pay close attention to what their current marginal tax rate is, what it was when they were fully employed, and what it is anticipated to be at retirement.

Jamie Golombek, managing director, tax and estate planning with CIBC in Toronto, says taxes are not the only important consideration. “For someone concerned about job security, it’s a lot easier to take money—even psychologically—out of the TFSA. Even though it might make sense mathematically to put money into an RRSP today, if you’re going to be forced to take it out in the short term and lose the contribution room and pay taxes, the added comfort of the TFSA can go beyond the mathematics behind TFSA versus RRSP.”

Optimizing use of tax shelter

Perhaps it’s the word savings that causes people to limit the way they use the TFSA (statistics show that an overwhelming 94% of TFSA assets are parked in savings accounts or fixed-term deposits).

Golombek says concentrating interest-bearing investments in a TFSA is not the best way of using the tax sheltering, and recommends investors—particularly the younger ones with longer time horizons—consider a balanced approach.

He acknowledges there are advisors who argue asset classes should be separated and placed into a specific account type. Such advisors recommend putting interest-bearing products into tax-sheltered accounts and equities into taxable non-registered accounts. The most common rationale for this treatment is tax efficiency.

Carroll, however, disagrees with the benefits of this approach. “I’ve never seen anything that proves that it is an effective approach and so I’d be inclined to say if I got a place for tax-free returns, I want my returns to be as high as possible.”

Therefore, in the long run if equities are anticipated to produce higher returns than fixed income, then some equities should be added to a TFSA portfolio, says Carroll. That way, the TFSA account has a better opportunity of producing higher returns, as opposed to a lower return from a portfolio with only fixed income products.

For high-net-worth clients, TFSAs don’t typically make a significant savings vehicle. Golombek says clients from this income bracket will sometimes take advantage of the tax shelter of a TFSA by investing in speculative stocks. Investments they believe have the prospect of producing high returns can be sheltered from tax. The drawback: if the investment goes south, the capital losses in a TFSA cannot be used.

Given that some financial institutions allow the use of TFSA assets as loan collateral, for some investors the TFSA can be used to diversify assets and increase portfolio size. Currently the loan size would likely be small because the TFSA has only attracted $10,000 of contribution room, but over time that will gradually increase.

Helping future generations

At some point, some high-net-worth investors will realize they won’t spend all their assets before they die, and would like to pass some wealth to the younger generation. TFSA can play a role here as well.

For example, grandparents who want to give their grandchildren a head start in life can begin by gifting $5,000 for a TFSA of a beneficiary who is 18 years old. Each year thereafter, they can continue transferring assets for the TFSA to the grandchild. The transfers can be made in cash, or in kind. For in-kind transfers of stocks that have fallen in value, the capital losses can be claimed by the grandparents.

“Once the grandchild gets to an income level [at which] he or she would like to reduce taxes, they could take the TFSA money that’s accumulated and use that to make RRSP contributions when they get to a higher tax bracket,” says Carroll. “Because they are at a higher tax bracket, they get the tax benefit of reducing down the marginal taxes associated with those contributions at that higher tax bracket and they’ll get back the TFSA contribution room the following January.”

The transfers can be made in cash, or in kind. For in-kind transfers of stocks that have fallen in value, the capital losses cannot be claimed by the transferor. Of course, using the TFSA as an inheritance vehicle raises control issues. Grandparents cannot tell beneficiaries how to use those funds because there are no legal provisions that allow for any third-party control of the assets inside the TFSA.

Can the TFSA be taxed?

When the TFSA was introduced, the government lost approximately $5 million in revenue in fiscal 2008/2009. The foregone government revenue is anticipated to spike even higher over time—$290 million by 2011 and about $3 billion annually in 20 years. As TFSAs become a significant source of non-taxable retirement income, there is the possibility more people will qualify for government benefits, such as OAS and GIS. The net effect would be larger losses in government revenues along with increases in government benefit payments. This raises the question whether the TFSA is sustainable in the long run, and if its tax treatment can be reversed in the future.

In the U.K., the government has addressed this concern by pledging not to tax the ISA for the next 10 years.

Carroll says in Canada there’s nothing to stop the government from taxing TFSAs. “I think if they chose to do it, and I think there is certainly that possibility, they would have to allow for some type of grandfathering treatment,” he says. “There would have to be a line drawn in the sand at whatever point they make that policy announcement to provide some kind of grandfathering.”

He expects there will be a date chosen after which the plan will be taxed. “I think that is probably the worst that you can expect to occur with something of that nature,” Carroll says.

---

Rayann Huang is a Toronto-based financial writer.

---

Rayann Huang