Tag: TFSA

Income splitting in the TFSA era

The practice of income splitting has been around for decades.  Essentially it is the process of shifting income recognition from a high tax bracket individual to a low bracket individual, most often carried out between spouses.

With the implementation of the tax-free savings account (TFSA) in 2009, another legal avenue has opened up for those seeking to reduce household tax costs, both on its own and potentially in coordination with existing strategies.

Existing splitting strategies

Tax authorities will often seek to impugn aggressive splitting practices by attributing income apparently earned by a low bracket spouse back to a high bracket spouse. Still, there are many common strategies that are allowed and indeed encouraged by our income tax laws.

Second-generation income – Once income has been earned and recognized, the income on that income is taxable to the receiver spouse.  For this reason, one may choose to turn over such a portfolio more often in order to move more quickly into next generation income. 

Spousal loans – Income earned on money loaned from a high bracket spouse to a low bracket spouse will be taxed in the latter’s hands so long as required interest is paid.  Ironically, the recent economic downturn carried with it a positive twist for such loans as the prescribed rate has been at its lowest calculated point of 1% for the last year.

Fair market value exchanges – If a low bracket spouse provides assets of fair market value equal to money provided by the high bracket spouse, income earned on that money will be taxed to the receiving spouse.

Pension income splitting – Since 2008, one may elect to have up to 50% of certain pension type income sources allocated and taxed to a spouse.

Spousal RRSP – Contributions to a spousal RRSP may be withdrawn by that spouse and taxed to him or her in the 3rd calendar year after last contribution.  While taking care not to imperil later retirement needs, some such withdrawals could be timed to coincide with a spouse’s temporary low income period, such as a sabbatical or maternity leave. 

CPP pension sharing – Spouses may pool and then split their pension credits in order to shift some of the entitlement and taxation to the low income spouse.

TFSA strategies

One may provide money for a spouse’s TFSA, and the growth in value of the TFSA will belong to that spouse.  Essentially there is no income to be attributed.  That’s a $5,000 non-attributable deposit generating tax-sheltered income each year, with that figure indexed to inflation every 3 or 4 years.

To put the value of TFSA contribution room in perspective, remember that TFSA deposits are after-tax.  For a rough estimate of how that compares to pre-tax RRSP room, one divides by “1 minus marginal tax rate”.  For two spouses operating under a single income in a 45% bracket, their combined TFSA room equates to about $18,000 as a pre-tax figure – almost doubling the $21,000 tax sheltering room available under the RRSP alone in 2010.

If desired, that receiving low bracket spouse could pledge the TFSA as collateral to a lender in order to leverage invested assets.  As legal owner of the TFSA, all associated income would be that of the low income spouse, and of course the interest charges should be deductible. 

Arguably, the receiving spouse could employ the earnings from this leveraged strategy to assist in existing splitting strategies, for example to facilitate the eventual retirement of outstanding prescribed rate loans.  Care must be taken however to assure that the particular steps do not cross one over into the TFSA advantage rules and/or fall within the purview of the GAAR.  For these reasons, qualified tax advice should be sought before undertaking any more elaborate steps beyond plain vanilla spousal TFSA contributions.

Whether wealthy or not, the TFSA rules offer one further advantage to spouses, which is the ability to name a spouse as successor account holder.  At death, the account may roll to the survivor spouse, while having no effect on his or her TFSA room.  Be aware though that any unused TFSA room of the deceased spouse is forever lost.  

Accordingly, in situations where a serious illness has thrust upon the couple the need for terminal estate planning, it may be prudent to fund-up a TFSA before death, using a loan if necessary.  The loan could be retired after account transfer following death, thus preserving as much tax sheltering as possible for the widowed spouse.

Yes Advisor, there is an RRSP season

It’s a decades-old debate:  Should an advisor treat the first 60 days of the year as RRSP season?  

From a technical perspective, investors are effectively timing the market by contributing strictly in the first 60 days.  This could work for or against them, but it’s a risky proposition to skew the deposit timeframe to such a limited window.

From a tax perspective, many people are motivated by creating a tax refund.  Of course, this is really an interest-free loan to the government, though of relatively short duration if one contributes as late as possible and files the tax return as soon as possible.  

Finally, from a marketing and administrative perspective, many advisors extol the virtues of monthly PAC programs over the one-time hit.  Combine that with reducing tax at source with CRA Form T1213, and there is a case to be made (with numbers behind it) that one can accumulate more by ignoring the first 60 days allure.

Still, the reality is that industry advertising ramps up – and therefore clients’ ears perk up – as March 1 approaches.  In addition, many annual bonuses are paid after year-end, often near the end of February, so advisors who ignore such events may be doing so at their peril.

Thus whether we like it or not, there will always be those who, by choice or circumstance, focus their registered investment efforts on those first 60 days.

The TFSA era

While not specifically directed toward retirement, the tax-free savings account can be coordinated with the traditional RRSP to optimize savings.

No doubt clients have asked you whether they should be contributing towards RRSP or TFSA.  For those who are awash in cash, it’s hard to imagine that one would not be maxing out both types of plans.  Assuming limited resources, however, should a person contribute to RRSP, TFSA or both?

Recall the basic structure of the two plan types:

                                                   RRSP       TFSA

Tax-free funding                  Y              N      

Tax-free growth                   Y              Y

Tax-free withdrawals       N              Y

Viewed in this manner, it is clear that the name “tax-free savings account” is a bit of a misnomer.  What the plan really does – relative to an RRSP – is change the point at which tax is applied, though both plan types are entitled to internal tax-free growth.

Assuming the same investment choices in each plan, where a person’s marginal tax rate (MTR) is the same on deposit as on withdrawal, the net money on withdrawal will be the same under either plan.  Where deposit MTR is higher than the withdrawal MTR, the RRSP will result in more net money – The reverse is also true.

Relative marginal tax rate              Favours 

Contribution MTR higher              RRSP                     

MTRs the same                                Neither

Withdrawal MTR higher               TFSA

Of course the common expectation is that a working person moves to a lower MTR in retirement, but that may not be the case for those early in a career, taking a sabbatical or on variable commission income.  As well, if the savings are targeted for sooner use, such as a house or auto purchase, then it is the MTR at that time that is relevant.  

Consider also:

  • Unused contribution room carries forward for both plan types
  • For an RRSP contribution, the related deduction can be deferred to a later year, presumably when the person is at a higher MTR
  • Alternatively, a current contribution to a TFSA could be withdrawn at a later year to service carried forward RRSP room, and that withdrawal recovers TFSA room  

Ultimately the appropriate option will depend on an investor’s current conditions and future intentions.  Though not so simple, it can be reasoned out with good information.  

Changes to the CPP

The Canada Pension Plan comes up for formal review on a triennial basis.  A number of significant changes were recommended in the most recent review in the early part of 2009, and these have made their way into law with Royal Assent granted to Bill C-15 on December 15, 2009.

These changes, particularly the early and late take-up adjustments, present financial planners with an opportunity to provide insight and guidance to clients in determining how best to manage their CPP pensions.

Work cessation test – Until now, a person under age 65 had to cease working in order to commence a CPP pension, though there was no requirement that the person remain as such thereafter.  Accordingly, a person might ‘retire’ to commence the pension, and return to work after two months.  The work cessation test has now been eliminated, so that a pension may be commenced without this unnecessary work interruption.  This change will not affect existing CPP beneficiaries or those who take their CPP retirement pension before 2012.

Working beneficiaries participating in the CPP – In the past, once a pension had begun, there would be no further CPP premiums paid.  It is now mandatory for those under age 65 to pay the premiums, and voluntary from age 65 to 70.  This includes the requirement that the employer pays its matching portion.   These contributions will result in increased retirement benefits, earned at a rate of 1/40th of the maximum pension amount ($11,210 in 2010) per year of additional contributions.  The exact amount of the additional benefit would depend on the earnings level of the contributor.  The resulting pension could be above the maximum.  

General low earnings drop-out – The pension entitlement calculation currently allows a pensioner to drop off 15% of the years where earnings are low or nil.  This amounts to about 7 years.  The drop-out rate will be increased to 16% in 2012 and 17% in 2014, being an increase to about 7.5 and 8 years respectively. This change will not affect existing CPP beneficiaries or those who take their benefit before the change comes into effect.  

Adjustments for early and late CPP take-up – The current adjustments reduce a pension by 0.5% per month the pension begins before the normal age of 65, or increase it by 0.5% for each month after the 65th birthday month.  The early pension reduction will be gradually increased to 0.6%, spreading the implementation over a period of five years starting in 2012.  The late pension augmentation will be gradually increased to 0.7%, spreading the implementation over a period of three years, starting in 2011.  Once again, these changes will not affect existing CPP beneficiaries or those who take their benefit before the changes come into effect.  

Retirement savings and pension reform

The economic turmoil in 2008 played havoc with a wide swath of investments, but may have had especially dire consequences for those in retirement.  While the preceding issues have a practical bent that an advisor may be able to act upon immediately, there could be some broad-reaching structural changes ahead.

At the May 2009 meeting of Federal-Provincial-Territorial Ministers of Finance, a Research Working Group was struck to looking into Retirement Income Adequacy, with six research tracks established for examination: 

  • Justifications for government involvement in retirement income provision 
  • Current and future retiree savings levels among Canadian households
  • Investment risk and longevity risk in the context of retirement income
  • Impact of investment performance and costs of pension and other retirement savings. 
  • Efficiency and effectiveness of tax-sheltered savings instruments design in Canada
  • An international perspective of Canada’s retirement income system.

A 30-page summary document was delivered to the December 2009 meeting of those same Ministers in Whitehorse.  That document is available at www.fin.gc.ca/activty/pubs/pension/riar-narr-eng.asp, including links to the six underlying papers.  The Ministers have committed to conduct public consultations in their respective provinces/territories before reconvening in May with the intention to move toward more concrete decisions.  The options being considered include (and these should not be considered as mutually exclusive):

  • Establishing a voluntary supplementary CPP program
  • Extension of the CPP itself, in terms of both premiums and benefits
  • Greater leeway to financial issuers to set up group savings plans
  • A stronger delivery of public education on the savings vehicles available

As a total aside

Kudos to the province of Quebec for allowing donations to the victims of the January Haiti Earthquake to be reportable for the 2009 tax year.  In addition to providing tax relief to thoughtful donors a year earlier than otherwise available, the move is designed to encourage early action, with the qualification period ending February 28, 2010.  As of publishing deadline, there was no similar relief in other provinces or at the federal level, but hopefully those governments will follow the lead.

Making room for TFSA: Indexing the dollar limit

What a year we have just seen.  From the precipitous market drop, to that quick climb last spring, and on through the current path – it’s been a wild ride. 

And what an introduction for the tax-free savings account!

Who would have thought that one of most innovative wealth vehicles in Canadian history would be trying to find its legs in one of the most challenging markets of the past century?

No doubt you’ve been exposed to the TFSA surveys conducted by various industry players.  Whether reporting account activity or gauging future intentions, it appears that the take-up on available contribution room has been a bit modest to date.  

Rather than being a commentary on the TFSA itself, this is likely a reflection of those tumultuous markets and the general trepidation of the investing public.  Through the combination of continuing government support, financial industry promotion, and a return of investor confidence, this hesitation should eventually give way to greater investor understanding and adoption of TFSAs.

Still, even if investors are willing to take the plunge, has recent market turmoil seriously impaired investors’ ability to make best use of TFSAs?  Specifically, what effect might the timing of this economic downturn have on TFSA contribution room?

Indexing contribution room

One of the distinctive aspects of the TFSA offering is the manner by which contribution room is designed to keep up with inflation.  We won’t see the same kind of year-to-year indexing as is used for most other elements of our tax system, such as the adjustments in brackets and tax credits that get down to the individual dollar.

Instead, the original $5,000 annual TFSA dollar limit available in 2009 is to be bumped every few years by $500 increments.  This ‘bump’ is really a rounded representation of an underlying base figure that, like those other indexed elements, is adjusted annually.  It is only when this base figure reaches the mid-point (eg., $5,250) that the dollar limit is taken to the next $500 threshold, in this case $5,500.

This process means that inherently the TFSA dollar limit will be slightly behind inflation initially, and slightly ahead as each threshold is reached.  On balance over the long term, it keeps in sync with inflation with the further benefit that there is an elegant simplicity to using periodic $500 jumps rather than annual odd dollar changes.  

That first $500 threshold?  

While somewhat unique in its stepped application, the formula and procedure for determining the dollar limit is roughly the same as for other indexed amounts.

The indexation factor is derived by comparing the annual consumer price index to September 30 for a given year against the preceding year.  This means that 2010 indexing is based on CPI growth from September 2008 to September 2009, which computes to a mere 0.6%. Our underlying base figure for TFSA dollar limit in 2010 is therefore $5,029.

TABLE: Recent years’ indexation factors

  2006      2007       2008       2009

2.33%    2.10%       1.9%      2.5%

At TFSA launch time in 2009, it was expected that the first increase in the limit to $5,500 would occur in 2012.  Indeed, had we experienced constant 2% inflation in the past year and in coming years, that would have held true.  Now, we’re looking at 2013 if we immediately come back to 2%, though perhaps we will see a higher factor in the coming year that puts it back on track.  Remember though that this “factor” is just a reflection of inflation, so don’t wish too hard.

For some historical context, the indexation factor in the preceding four years has been about 2% or so.  (See Table.)   As well, consider that the Bank of Canada’s approach is to attempt to keep inflation within the 1% to 3% range, with a target of 2%.  Assuming the BoC is effective over the longer term, we can expect to see the limit raised about every 4 years. 

Your annual client reminder

Don’t dwell too long on when those increases may be coming.  The key is to remind your clients in those annual reviews that they get more room every year, and they should make good use of it.  As well, check the age of their children to get them started, too.  

In that light, I was floored when I realized that 1992 is the birth year for those turning 18 in 2010, as my own nephew – my parents’ first grandchild – was born that year.  Here’s my reminder to my brother:

Happy birthday to you
Born in ninety-two
TFSA room
Is waiting for you

Oh, and many happy returns – both personal and financial!