As January 2009 is fast approaching, Tax-Free Savings accounts are often
seen in the headlines or being advertised at your local bank.
The new Tax-Free Savings Account (TFSA) is a registered account in which
investment earning, including capital gains accumulate tax free.
Taxpayers over the age of 17 may contribute up to $5,000 each year to
such an account. If a taxpayer's contribution room is not used in one
year it may be carried forward to the next year allowing for a larger
contribution in that year. Unlike the RRSP, contributions to a TSFA do
not result in an income tax deduction and withdrawals from a TFSA are
not reported as income nor be included in income for any income-tested
benefits, such as the Canada Child Tax Benefit or Goods and Services Tax
Credit.
The CRA will establish contribution room for all taxpayers on the basis
of income tax returns filed. Taxpayers who do not file for a number of
years may establish their contribution room by filing those returns.
Some common questions regarding TFSAs are as follows: Q: Can a corporation hold a Tax Free Savings Account (TFSA)? A: Legislation provides that an individual (other than a trust) who is
resident in Canada and 18 years of age or older would be eligible to
establish a TFSA. S. 248 of the Income Tax Act defines an individual as
a person other than a corporation. Thus, a corporation may not be
eligible establish a TFSA. Q: What slips are associated with a TFSA? A: At this time the only form that has been provided for a TFSA is Form
RC236 Application for a TFSA (Tax-Free Savings Account) Identification
Number. This form is for use by the issuers of a TFSA. No forms have
been announced for use by individuals.
CRA has announced that it will provide taxpayers the amount of the
available TFSA contribution room each year on their Notice of
Assessment, based on information provided by the issuers of the TFSA.
CRA has also indicated that taxpayers will have to file returns in order
to establish their contribution room.
In addition, the CRA has provided details of the information that TFSA
issuers must provide each year. These details include:
Name, date of birth, and Social Insurance Number of plan holder,
TFSA Account Number,
Details of each contribution, withdrawal, transfer in, and
transfer out,
Fair Market Value of the plan at December 31 of the taxation
year.
The deadline for the issuers to file their TFSA returns is 60 days after
the end of the taxation year.
Given that contributions are not deductible and withdrawals are not
taxable, it may well be that there will be no reporting requirements by
the individual plan holder. However, CRA has not made its intention
clear in this respect. CRA has confirmed that there will not be a
prescribed form for transfer of TFSA amounts between financial
institutions. Q: Can a Flow-Through Limited Partnership be held within an RRSP? Within a
TFSA? A: The same rules apply to an RRSP and TFSA. There are no specific
restrictions in the Income Tax Act for flow-through shares or limited
partnerships that invest in flow-through shares from being held within
an RRSP or TFSA, so long as they are listed on a prescribed stock
exchange in Canada. Typically, flow-through shares will not be publicly
traded during the first 18-24 months and will then be rolled over into a
mutual fund that is publicly traded. During the period that the
flow-through shares are not publicly traded, they are not eligible RRSP
or TFSA investments.
Caution should also be exercised when considering flow-through shares
(or limited partnerships that invest in flow-through shares) in either
an RRSP or a TFSA. Since neither an RRSP nor a TFSA can benefit from
the flow-through expenses, it may not make sense to purchase the
flow-through shares in an RRSP or TFSA.
Investors may consider whether it is a good idea to transfer those
shares or partnership units into their RRSP or TFSA after they have
deducted the flow-through deductions. If the shares are traded on a
prescribed exchange, such a transfer will result in a deemed disposition
for income tax purposes at the fair market value (FMV) of the shares.
The adjusted cost base of the shares will be zero so the entire FMV of
the shares will be reported as a capital gain.
If the shares or units increase in value the capital gain within the
TFSA will be tax-free. If they decrease in value, then the loss will
not be deductible. Given the tax-preferred treatment of capital gains,
investors should consider whether a registered account is really the
best place to hold such investments. On the other hand if the investor
feels that the investment will yield fully-taxable income, then the
tax-free status of the TFSA or tax-deferred status of the RRSP may be
beneficial. This information is used with the permission of Knowledge Bureau, Inc. For more information go to www.knowledgebureau.com.
More Information:
The new Tax Free Savings Account (TFSA) is an investment vehicle, unfortunately not available until 2009, that will allow Canadians over 18 to accumulate savings “room” of $5000 a year throughout their lifetime, and so with a life expectancy of approximately 80 years for the average Canadian, that means a funding potential of $310,000 over an average adult life span of 62 years.
Contributions to the account are not deductible, but earning accumulate on a tax free basis—including interest, dividends and capital gains—and withdrawals of both earnings and principle are tax exempt. However, those withdrawals will make new TFSA contribution room, on an indefinite carry forward basis, which provides us with some interesting new savings strategies for virtually every family member.
Moreover those withdrawals will not affect income-tested tax preferences like Child Tax Benefits, Employment Insurance Benefits or Old Age Security pension. This means you can earn the tax free investment income in the plan and avoid clawbacks, too. So how can Canadians take advantage of the plan? Several strategies come to mind:
Family Income Splitting. There is no attribution rule attached to the new TFSA—resulting income is tax exempt. So this is a great opportunity for parents and grandparents to transfer $5000 per year to each adult child in the family—for the rest of their lives. Recipients can take the money out for what ever purpose they wish and create new TFSA contribution room; which means they can put it back to grow when the withdrawal need is met and new savings are achieved. This will be welcome news to grandparents in particular.
Leveraging Tax Preferences: Consider funding this new “bucket of savings' with your RRSP tax savings—a great way to leverage two available tax provisions. But also look at your new investment options from the tax-exempt income within the TFSA. For example, it may make some sense to look at the tax-free income in the TFSA as a source for funding assets that will multiple on a tax exempt basis: for example life insurance, critical illness insurance or a tax exempt principle residence.
TFSA or HBP? In the market to buy a new home. Consider whether it makes more sense to withdraw funds on a tax free basis from within an RRSP to fund a new home purchase under the Home buyers Plan or should the taxpayer save and withdraw funds under the TFSA instead? Certainly there are no tax penalties for failure to pay back the funds to the TFSA, and withdrawals automatically create new TFSA contribution room, so our vote would be to accumulate money in this new savings vehicle instead.
TFSA or LLP? Education savings strategies should now be revisited as well for similar reasons as outlined in the last point. Saving within the TFSA allows you to accumulate funds on a tax-deferred basis and then withdraw them without penalty or a requirement to repay the funds. This is not so under the Lifelong Learning Plan, which allows for a tax-free withdrawal from the RRSP but requires an annual repayment schedule. The avoidance of income inclusion penalties therefore makes the TFSA a more attractive withdrawal vehicle for these purposes than the Lifelong Learning Plan. Better to leave the funds in the RRSP for tax deferred retirement savings.
TFSA or RESP? This new account would also appear to be a better savings vehicle for education purposes than the RESP, which eventually could provide a tax penalty on withdrawal if intended recipients do not end up going to school. However, in making this choice the investor misses out on the Canada Education Savings Plan sweetener.
Offsetting Pension Contribution Limitations. Contributors to employer pension plans are often precluded from making RRSP contributions because of their pension adjustment amount. Likewise those who have contributed the maximum to an RRSP—18% of earned income to $20,000 in 2008 and want to do more to supplement their savings on a tax-assisted basis—now have the opportunity to tap into another tax deferred savings opportunity. In particular the TFSA a good place to park interest-bearing investments.
Supplementing Executive Pension Funding: Executives who earn more than $111,111 in 2007 will be unable to save for retirement on a tax assisted basis for income above this amount. The TFSA provides a small window of opportunity to shore that tax assistance up. This option should be employed in conjunction with planning for funding of top hat plans like Individual Pension Plans or Retirement Compensation Arrangements.
New Tax Sheltering Opportunities for more Pre-Retirees: The TFSA is a great savings option for people who do not have the required earned income for RRSP contribution purposes and therefore have few opportunities for tax sheltered retirement savings. This includes those in receipt of inactive income sources like pension income, investment income or employment insurance benefits.
New Tax Sheltering Opportunities for RRSP Age-Ineligible Taxpayers: The tax shelter can continue for those who reach age 71 and don't need the money in their RRSP. While withdrawals must be generated under the usual rules, reinvestment into a TFSA will allow those tax-paid funds to grow again—faster—in a tax sheltered account, as opposed to a non-registered account.
Benefits for Single Seniors: RRSP Melt Down Strategy Enhancements: It has always made some sense to melt down RRSPs to “top income up to bracket” in circumstances where taxes will be higher at death than during life. We generally use that strategy for singles or widow(er)s for example. Now surplus funds can be deposited into the TFSA so that retirees can continue to build wealth on a tax deferred basis and keep legacies intact.
TFSA Borrowing and Excess Contribution Penalties: Because income from the TFSA is not taxable, borrowing funds to contribute to a TFSA will not be tax deductible. Using borrowed money to invest in non-registered accounts makes more sense as interest is then tax deductible. Also be aware that the new provision will result in a penalty of 1% per month if excess contributions are made to the account. Therefore it pays to look carefully at your Notice of Assessment from CRA.
Estate Planning Considerations. Also note that the TFSA loses its tax-exempt status after the death of the plan holder, meaning that the investment income will become taxable, however a rollover opportunity is possible when the spouse or common-law partner becomes the successor account holder. This will not be affected by the spouse's contribution room and will not reduce existing room either. However, when a child dies without a spouse, the plan should be collapsed or transferred to another appropriate savings vehicle.
Marriage Breakdown: Investors in the TFSA will be able to transfer from one party to the split to the other on a no-penalty basis, however, the transfer in this case will not re-instate contribution room for the transferor. Nor will it affect the contribution room of the transferee.
File a Tax Return: yet another reason to endear oneself to the tax system: a return is required to build TFSA contribution room and so it is folly to file late or miss filing a return. Remember there is a statute of limitations of ten years in filing late or adjusted returns. Don't cut into your tax exempt wealth accumulation potential by being tardy on this front.
Investment Ordering Decisions. The New TFSA requires a second look at the order in which investors maximize accumulation activities. Taxable investors should consider family priorities and then contribute funds in this order:
To an RPP
To an RRSP (including spousal RRSP)
To a the TFSA
To RESPs (Registered Education Savings accounts to maximize Canada Education Savings Grants and Bonds)
To RDSPs (Registered Disability Savings Plans to maximize Canada Disability Savings Grants and bonds.)
To non-registered accounts
This information is used with the permission of Knowledge Bureau, Inc. For more information go to www.knowledgebureau.com.
