TFSA – Page 3 – Doug Carroll

5undamentals – TFSA – Tax-free Savings Account

1. What is a TFSA?

Purpose – The TFSA is a flexible savings plan that can be used (and re-used) for any savings purpose over a person’s lifetime. It is registered under the Income Tax Act, entitling it to special tax treatment. Compared to other registered plans, the TFSA has relatively few rules to understand and follow.

Investment options – Qualified investments are similar to RRSPs and other registered plans. Options include money accounts, deposits with a regulated financial institution and guaranteed investment certificates; stocks, bonds and most other securities listed on a designated stock exchange; and mutual funds and segregated funds.

2. Who can use it?

Eligible contributors – To use a TFSA, a person must be a Canadian resident over the age of 18. When you open an account, your financial institution will require proper identification, your Social Insurance Number (SIN) as a tax requirement, and other information according to securities regulations.

Age 18 contributors – A person must be 18 to open a TFSA, and will be entitled to the TFSA dollar limit (discussed below) for that full year, not pro-rated by birthday. If the person cannot enter a contract until age 19 if that is the province’s age of majority, the TFSA limit/room for the age 18 year carries forward.

Upper age limit – There is none.

Foreign citizens – Eligibility is based on being a legal Canadian resident, regardless of citizenship. For Americans (and possibly others), their home country tax rules may influence whether to use a TFSA.

3. How it works – Key tax features

In, within and out – Whereas RRSP contributions are deductible and withdrawals taxable, for TFSAs:

Contributions are after-tax, meaning they are NOT deductible in calculating current income.
Income and growth within the plan are NOT taxable.
Withdrawals from the plan are NOT taxable.

Over-contributions – If your TFSA contributions exceed your TFSA contribution room recorded at the beginning of the year, you are said to have an excess TFSA amount. If this is the case at any time in a month, you are liable to a penalty tax of 1% on your highest excess TFSA amount in that month.

Non-resident contributions – If, at any time during the year, your TFSA contains contributions you made while a non-resident of Canada, you will be subject to a tax of 1% per-month on these contributions.

4. Contributions and withdrawals

TFSA dollar limit – As a Canadian resident who is 18 at any time in a year, you are entitled to the annual TFSA dollar limit. The limit was $5,000 from 2009-12, $5,500 from 2013-14, $10,000 in 2015, $5,500 from 2016-18, and $6,000 in 2019-20. It is indexed to inflation and rounded to the nearest $500.

Unused room – Your unused room is carried forward for you to use in any future year.

In-kind transfers – You may transfer securities in-kind to a TFSA, but the transaction may trigger tax. If it originates from a non-registered account, there is a deemed disposition at fair market value (FMV) that may result in a taxable capital gain. If the source is your RRSP, it will be treated as a withdrawal at FMV.

Credit for withdrawals – When you make a withdrawal, you get a dollar-for-dollar credit to re-contribute to your TFSA. The credit applies the following January 1^st. If you re-contribute in the current year, you may exceed your contribution room and face the 1% penalty tax.

TFSA-to-TFSA transfers – If you want to move funds from one TFSA account to another, whether at the same institution or another, do so as a direct transfer so as not to affect your TFSA room. There is no prescribed form for this purpose, so some companies use their own form or use CRA Form T2033.

Loan interest – TFSA income is tax-exempt, so interest on a loan to invest in a TFSA is not deductible.

5. Life events, and death

Income splitting with spouse / common law partner (CLP) – Generally if you make a gift to a spouse/CLP that is put into passive investments, tax on that income will be attributed to you the giver. However, those attribution rules don’t apply if your spouse/CLP places the gifted money in a TFSA.

Relationship breakdown – A direct transfer of a TFSA to a separated spouse/CLP will not affect either person’s TFSA room. The recipient’s room is not reduced by the receipt, and the transferor receives no credit to recover room as this is not a withdrawal. You must be living separate and apart at the time of transfer, and the transfer amount must be pursuant to a separation agreement or court order.

Becoming non-resident – If you become non-resident, there is no tax on a TFSA at that event nor while you remain non-resident, and any earnings or withdrawals will still not be taxed in Canada. You will not accrue any annual room while non-resident. Withdrawals are allowed, and those will be credited toward room the following year, but you may only use that room if you re-establish Canadian residency.

Death: Designated beneficiary generally – You may designate one or more beneficiaries on the TFSA contract, and he/she/they will receive the plan value at date of death without any tax reduction. Any growth from time of death until the transfer is taxable to the beneficiary/ies.

Death: Spouse as designated beneficiary – If you die having designated your spouse/CLP as beneficiary on the TFSA contract, he/she may contribute and designate all or a portion of the payment as an exempt contribution to their own TFSA, without affecting their own unused TFSA room. Again though, any growth from time of death until transfer is taxable to the spouse beneficiary. To qualify for the rollover, transfer must occur before the end of the calendar year after the year of death.

Death: Spouse/CLP as “successor holder” – If you die having designated your spouse/CLP as successor holder, he/she becomes the new holder of the TFSA without affecting his/her existing TFSA room. This designation will be effective whether it is made on the TFSA contract or in the original holder’s Will. In this case though, the transfer is deemed to occur at the date of death, so any post-death growth will not be taxable as it will occur within the survivor spouse’s TFSA. Once more, to qualify for the rollover, transfer must occur before the end of the calendar year after the year of death.

Death: Spouse as estate beneficiary – A TFSA paid to the deceased’s estate may be subject to provincial probate tax. A spouse/CLP who has a sufficient financial entitlement as a beneficiary of the estate may make an exempt contribution with the same effect as being a designated beneficiary on the TFSA contract. Interim growth is again taxable to the spouse/CLP. To qualify for the rollover, transfer must occur before the end of the calendar year after the year of death.

Death: Unused TFSA room – Unused room cannot be transferred to anyone at death.

Magic Number – What are some advisor assumptions on how much to save?

How much do I need to save for retirement? It’s the most common question asked of financial planners.

Of course, the response depends on how much you’ve already set aside, how much you need to live on now, and how much you want to (or must) spend in those later years. That’s the core of financial planning, and there’s a lot of information to be gathered, decisions and assumptions to be made, and calculations to be applied to come up with viable options and sound recommendations — and even then, there is still some degree of uncertainty.

This doesn’t mean that you don’t go to the effort, particularly if you are the financial planner tasked to make those recommendations. The critical step of any plan though, is putting it in motion.

Heuristics – The appeal of simplicity

In the face of what may feel like a laborious and elusive task, people often prefer to use a heuristic, for example “save 10 per cent of your income.” This is also known as the 10 per cent rule. Because it is so simple, it may very well get things moving, which in fairness, is a victory in itself.

Once good saving habits are established and experience gained, adjustments can be made that cater to changing circumstances.

Even so, 10 per cent is just a nice, round, but otherwise arbitrary figure. The aura that surrounds it should not be confused with the principled due diligence that informs good financial planning.

Do you apply it before or after…?

If we’re not careful, the apparent simplicity can be misleading. How you apply it is equally and arguably more important than the rate you choose in the first place. Too little and there’s not enough when you need it. Too much and the budget stress could be overwhelming, perhaps leading you to abandon the initiative you have taken. Consider these key tax issues:

Is the 10 per cent set before or after income tax?

In other words, are you applying it to gross income or net income? As a rough example (which varies by province), the average tax rate at $100,000 is about 25 per cent.

So, do you target $10,000 based on the gross, or about $7,500 based on the net? That could hinge on the mechanics of how you save.

If you pre-calculated $10,000 then you could pre-authorize a proportionate dollar amount from each paycheque/auto-deposit.

If instead you took 10 per cent off each deposit after it is in your account, it would come out to $7,500.

Are you saving with before-tax or after-tax dollars?

As compared to the first question, which was about the amount to save, this is about deductibility. Put in more familiar terms, you could make a deductible RRSP contribution, or a non-deductible TFSA deposit.

While you can get more into the RRSP to begin, eventually that is taxed on withdrawal before you can spend. TFSAs face no further tax. You’ll need to look at tax rates now (known) and in retirement (assumed) to properly compare. If you’re doing some of each, the arithmetic is more challenging.

Pre- or post-payroll?

If you contribute to a workplace group RRSP, your employer will generally reduce its withholding tax, as it knows of this deduction. When you contribute to your own RRSP, the annual withholding will likely exceed your actual tax due, resulting in you receiving a tax refund. While you don’t have to, reinvesting the refund effectively boosts your savings rate.

Canada Pension Plan?

The CPP is a savings program, with a base premium of 4.95 per cent. It is withheld by your employer, so most people wouldn’t notice or think of it as saving, per se. But depending on your response on the preceding questions, it could be quietly baked into your savings rate. And with premiums increasing to 5.95 per cent over the next few years, and an additional four per cent premium on higher income levels after that, it warrants a closer look to make sure it dovetails with your intentions.

Housing and mortgage?

What does housing have to do with it? Well, equity in a house is a type of saving, usually by first saving a down payment then servicing a mortgage. As an owner, you defray some of your future shelter costs, whereas otherwise you would need more savings to pay future rent. Whether this is before, after, or part of your 10 per cent depends on your circumstances, which is why a holistic financial plan should underlie your efforts.

Three tips to jump-start your savings as your career gets going

You’ve spent a long time, a lot of effort and a fair bit of money to get going in your career. Now here you are launching into it, and likely the last thing you’re thinking about is … retirement.

Fair enough, let’s not stretch too many decades down the road, and just look a few years ahead for now. Why is it so important to get a savings habit going now? And how can taxes – yes, taxes – act as a strategic guide on where and when to invest those savings?

Save early, save often … and save smartly

In terms of what is saving smartly, ideally your savings will be flexible to be applied to your financial needs as they arise, and will take best advantage of tax-sheltering where possible.

Choices: RRSP and TFSA

While not the only place to put your savings, registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs) are common choices:

RRSP – You get a tax deduction for the amount you put in, there is no tax on earnings while in the plan, and then withdrawals are taxable.

TFSA – There is no tax deduction when money goes in, but similar to RRSPs there is no tax on earnings, and all withdrawals are tax-free.

In a sense, the RRSP and TFSA mirror one another in that the big tax break comes at the beginning with the RRSP and at the end with the TFSA. Apart from the tax-sheltering (which both plans get), an RRSP makes sense for retirees because they expect to be in a lower bracket in retirement when withdrawals are taxed. If you used a TFSA for this purpose, it would cost you more tax than with the RRSP.

So if that’s the case, is there any situation when a TFSA would be preferred because someone goes up in tax bracket over time?

A tax strategy for young earners

Yes, and you’re it as a new entrant into the workforce. You’ve negotiated a fair wage to begin, but you expect that to rise as your career progresses. The value of the tax break on an RRSP contribution is more modest at this level than it will be when you fully hit your stride later on.

It may not sound appealing to allow yourself to be taxed now, but that’s what happens if you first contribute to a TFSA. Then when you get into that higher income (and tax) bracket, you can take your tax-free TFSA withdrawal to make your tax-deductible RRSP contribution. What you do with your eventual tax refund … well that’s a topic for another day.

What’s more, you are allowed to re-contribute to your TFSA in future years what you took out of it this year. With a little planning you can strategically use the TFSA over and again throughout your life. Of course there’s much more to consider than this little tax hook, not the least of which is the choice of investments within the accounts. That’s where a conversation with your financial advisor can help you decide if and how to apply this strategy in your situation.