TFSAs and non-registered accounts

Should clients put their money into a TFSA or a non-registered account? Although the answer may seem obvious, a discussion about why the TFSA is advantageous has its merits.

In two respects, TFSAs and non-registered accounts are identical. Account holders must be 18 years or older (technically, there’s no age requirement for non-registered accounts, but minors generally are not allowed to hold trading accounts), and neither allows a tax deduction on contributions.

Beyond these basics, there are significant differences to explain to clients. TFSAs, as we’ve noted before, have an annual contribution limit of $5,000 (indexed to inflation, with unused room carried forward indefinitely). Excess contributions are penalized at a rate of 1% per month and eligible investments, such as cash, stocks, bonds and mutual funds, are similar to those for an RRSP. Non-registered accounts have none of these limitations (but usually include cash, stocks, bonds and mutual funds).

Carrying charges for a TFSA are not tax-deductible because in general, the charges are not incurred to earn taxable income. Any income generated within a TFSA is tax-free. Because earnings generated within a non-registered account are taxable, the opposite is generally true.

Therefore, a client who makes a leveraged investment should invest the borrowed funds in a non-registered account if he or she wants to deduct the interest on the investment loan. The client would still need to demonstrate the borrowed funds were used for the purpose of earning taxable income, but most mutual funds and common stock would pass the test.

There are a few income-splitting opportunities for couples if only one spouse earns income. Generally, attribution rules prevent a spouse in a high-tax bracket from transferring assets to a spouse in a low bracket in an attempt to reduce the overall tax rate. The good news is that income earned from contributions to the TFSA of a spouse or common-law partner is not attributed back to the contributor. The attribution rules do not apply since the income in the TFSA is tax-free. There is no taxable income to attribute back to the contributing spouse. It’s not that the attribution rules have changed; they simply do not apply to TFSAs.

The attribution rules will continue to apply to non-registered accounts as they always have. Given the few income-splitting opportunities, you won’t want to miss telling your clients about one that is this easy.

Legacy planning

On the death of a TFSA holder, there is a deemed disposition, but it is tax-free. There is also a deemed disposition on the death of a non-registered account holder, but, of course, this disposition is taxable. Since the estate doesn’t pay tax on the TFSA, the inheritance is larger. This could be a key factor for those who want to leave a legacy to their heirs (and have sufficient time to build a TFSA). If there is a surviving spouse, both the TFSA and non-registered account can be transferred to the survivor without immediate tax consequences. In the case of the non-registered account, the taxes are merely deferred and payable on the death of the survivor.

One advantage of a non-registered account is realized capital losses can be used to offset realized capital gains. If there are no capital gains in the current year, then the losses can be carried back and applied against gains in the three previous taxation years or carried forward indefinitely and claimed against future capital gains. When a capital loss is realized in a TFSA, it cannot be used to offset taxable capital gains.

These exceptions aside, a TFSA will be the natural choice for many clients. To this end, let’s consider some scenarios in which either a TFSA or non-registered account could be employed to meet a financial goal. Using real-life scenarios can make it easier for clients to understand the right direction. For a real-life scenario, we chose some common savings goals, applied some assumptions on rates of returns and inflation rates along with the appropriate tax rates, to see which could help a client reach his or her goal faster — a TFSA or a non-registered investment.

I do want to state that these scenarios are based on hypothetical rates of return, though they’re consistent with how a balanced mutual fund portfolio consisting of equities, fixed income and cash-equivalents has performed over the past 10 years.

For our scenario, we consider two clients who are planning to buy a car in five years. Client A puts $5,000 a year for five years in a non-registered account and Client B invests the same amount for five years in a TFSA.

Even in this short time period, Client B, who used a TFSA, is expected to realize $2,000 more for her investments than Client A. This is simply the result of the investment income and gains generated within a TFSA not being subject to annual taxation. As well, any withdrawals made from the account are processed tax-free. When you look even further out, say 10, 15 or 20 years, the benefits of investing in a TFSA keep increasing. In 20 years, Client B, who diligently invested $5,000 a year in her TFSA and invested wisely, could see tens of thousands of additional dollars than Client A with his non-registered account.

What, then, is the key difference? For your clients, it will boil down to this: TFSAs have that seemingly small annual contribution limit of $5,000. However, since investment income, gains and withdrawals in TFSAs aren’t taxed, savings will actually grow faster than they might in a non-registered account.

Michelle Munro

Tax & Estate

Michelle Munro is director, tax planning, for Fidelity Investments Canada ULC.