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ArticlesA Wealth of Choices: Understanding the New Tax-Free Savings Account
First Posted: April 16, 2008 Many economists praised it as an affordable plan that will promote savings and help bolster the economy by providing more capital to corporations. And the Canadian Taxpayers Federation called it "an excellent policy proposal." What is it? The new Tax-Free Savings Account (TFSA) that was the focal point of Budget 2008. The new account not only can help you save, it can play significant roles in your estate and tax planning. Starting next year, Canadians aged 18 and older will be able to invest as much as $5,000 a year in a TFSA. The new account is the mirror image of an RRSP -- contributions are made with after-tax dollars, rather than pre-tax money, but withdrawals are tax-free. Withdrawals will add contribution room matching the amount taken out. In contrast, when you withdraw money from your RRSP you lose contribution room. In other words, if you withdraw $4,000 from your RRSP, $4,000 of your contribution room is lost forever. The same investments eligible for RRSPs are eligible for TFSAs. So you can hold a number of income-earning holdings in the account, including equities, bonds, mutual funds, savings accounts, and term deposits. (See Page 3 for a closer look at the benefits of TFSAs.) However, the point of the TFSAs is not to replace registered plans. In fact, all things being equal, the two plans are a wash as the table at the bottom of the article illustrates. There generally would be no advantage to either a TFSA or RRSP, although both can provide a better rate of return compared with unregistered savings. The only difference is that with an RRSP you receive an initial tax deduction, which leaves you with more pre-tax dollars to compound over the years. The after-tax TFSA contributions mean you essentially have less money to grow. Ideally, you would have both accounts and maximize their uses. Then you would have the flexibility to choose annually whether to pay tax on withdrawals from a registered plan. In some years you may want to keep taxable income low to minimize benefit clawbacks and in other years you may want some taxable income to account for losses. What all this means is that you have some planning to do with your accountant before the TFSA is introduced next year to determine how the new savings account might fit into your retirement, estate and tax strategies. Here are several possibilities to consider: 1. Shelter investment income Generally, TFSAs will work best with fixed income investments. But if you consider yourself a very good trader, you could trade stocks within the TFSA and profits will be tax-free. But, be wary. Capital gains inside a TFSA are tax-free, so you cannot claim a capital loss to offset other capital gains nor can you carry it forward. So if you own any laggard stocks, they would generally be wasted in a TFSA, while in a conventional investment account you can apply losses against taxable capital gains. Generally, high-income investors with extensive investments in non-registered plans might want to keep interest-paying investments in a TFSA and stocks outside. If you have small holdings outside a registered plan, you could consolidate into a TFSA. That could save you significant tax liabilities when you withdraw the money. It's not clear yet whether "in-kind" transfers from taxable plans to TFSAs would trigger capital gains. If such transfers were deemed a sale, you would be liable for capital gains taxes. If transfers weren't considered dispositions, you could conceivably reduce your unrealized capital gains liabilities over time. Similar to RRSPs, there is no limit on foreign content, potentially making the accounts a good place to park foreign investments that pay dividends or interest. Under conventional non-registered accounts, foreign dividends are considered income and are taxed at the full rate. They are not eligible for the dividend tax credit. In a TFSA those dividends would be tax free. If you happen to favour leveraged investing you can benefit by using a TFSA as collateral for low-interest investment loans. However, avoid using borrowed money to invest in a TFSA; the interest costs won't be deductible as they are in a conventional investment account. |
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