Federal Budget 2008
Tax-free savings accounts
A primer on the new budget measure
February 27, 2008
It'll be some time yet before we know if the TFSA acronym will become as familiar as that other tax-sheltered savings vehicle — the RRSP.
But in a budget that was slim on major new measures, the centrepiece announcement of a Tax-Free Savings Account attracted a lot of interest. In the financial community, opinions were divided on how popular the program will become. But there was general agreement that it has the potential to encourage Canadians to save — something that we're not doing much of now in the current low interest rate environment.
First, a quick recap of the rules:
- Beginning in 2009, Canadians 18 and older can contribute up to $5,000 a year to a TFSA.
- Unused contribution room can be carried forward indefinitely.
- Contributions are not deductible.
- Investments in the TFSA will grow tax-free.
- Withdrawals are tax-free and can be made at any time.
- Any amount withdrawn can be recontributed to a TFSA later without reducing contribution room.
- Any amount withdrawn from a TFSA will not result in a clawback of any federal means-tested program like Old Age Security, the Guaranteed Income Supplement, the Age Credit, the GST credit, and the Canada Child Tax Benefit.
- Amounts in a TFSA can be pledged as collateral, unlike an RRSP.
- Can include investments in GICs, stocks, mutual funds, bonds, like an RRSP.
- Contributions to a spouse or common-law partner's TFSA are allowed.
- The TFSA of a deceased holder can be passed tax-free to the TFSA of a spouse or partner.
"A lot of us have been asking for something like this for a while," says David Christianson, a senior financial planner at Wellington West Total Wealth Management in Winnipeg. "You used to be able to earn $1,000 a year in interest tax-free and that allowed people to keep an emergency fund around without being punished by taxes."
The TFSA will again allow Canadians to save for that rainy day without attracting a tax bill.
Many groups have lobbied for a program like the TFSA because it could allow lower-income seniors to avoid huge clawbacks of their Guaranteed Income Supplement by drawing money tax-free from their TFSAs, rather than from RRIFs, where payouts are fully taxed.
Others noted that TFSAs could be a good idea for those who have maxed out their RRSPs and still want to put aside money for their later years. They aren't a replacement for RRSPs, but a supplement.
The Canadian Taxpayers Federation — long critical of government tax policy — praised the TFSA as "an excellent policy proposal."
The Finance Department is certainly selling the TFSA hard. It's touting its new program as "the single most important personal savings vehicle since the introduction of the RRSP" in the 1950s. Time will tell, of course, but many financial advisers were quick to say there's a place for these accounts, depending on one's circumstances.
How exactly would a TFSA be more beneficial than just saving in a regular savings account?
The budget documents include a graphic showing the difference between saving in a TFSA and saving in a taxable savings vehicle. Let's assume someone contributed $200 a month for 20 years and earned a 5.5 per cent rate of return. In a TFSA, that would grow to be worth $87,525 — $48,000 in regular contributions and $39,525 in tax-free investment income.
Source: Dept. of Finance
In a regular savings account, tax would have to be paid on the interest, capital gains and dividend income earned each year over the 20 years. Assuming an average tax rate of 21 per cent on investment income made up of 40 per cent interest, 30 per cent dividends and 30 per cent capital gains, a middle-income earner would have $76,480 at the end of 20 years, according to Finance Department calculations. That's $11,045 less than with a TFSA. (Note: the Finance Department has a Tax-Free Savings Account calculator on its website so you can enter your own figures.)
So who are TFSAs really aimed at?
The government estimates that seniors will eventually receive about half of the total benefits provided by a TFSA. It expects that in the first five years of the program, more than three-quarters of the benefits will go to individuals in the two lowest tax brackets.
But it's clear that the TFSA is capable of fulfilling a variety of roles. An analysis by Scotia Capital declared that "its outstanding feature is its flexibility." There's no doubt that a TFSA can be used by any adult for a wide range of goals and time horizons.
BMO Capital Markets analysts suggested that "younger investors in low tax brackets expecting to make a large purchase down the road … will likely be big users."
Don Drummond, chief economist at TD Bank, thinks seniors will also be big users of TFSAs. "At age 71, you've got to start collapsing your RRSP, but a lot of [people] want to continue saving and I think they're massively going to turn to this vehicle," he told CBC News.
An analysis by the Burlington, Ont.-based WaterStreet Group suggested that people set up a TFSA for every child at age 18. "We're hard pressed to think of any example where the TFSA does not makes sense for an individual," write authors Tim Cestnick and Jeremy Nicholls.
Other possible TFSA uses, according to the Finance Department, include:
Using a TFSA to start a small business. Someone could contribute for years, withdraw all the money and the earnings tax-free, then recontribute to their TFSA that same amount years later, without reducing their contribution room.
Using a TFSA to save for an unforeseen emergency. Again, people who do this will be able to recontribute the full amount later without affecting their contribution room.
Using a TFSA to renovate a home. Withdrawing $20,000 tax-free on a TFSA might make more sense than raiding an RRSP. For one thing, the tax bill from an RRSP payout would require a withdrawal of as much as $37,000 from the RRSP to end up with $20,000 after tax. Also, withdrawing money from an RRSP means losing that contribution room forever, but a TFSA holder can always recontribute that $20,000 later.
What are the drawbacks, criticisms, caveats, and unknowns?
If you put a stock or mutual fund in a TFSA and it goes down in value by the time you sell it, it appears that you won't be able to claim a capital loss, which you could use to write off against a capital gain, as you could with an unregistered investment. CIBC World Markets chief economist Jeff Rubin — who is not among the early boosters of TFSAs — said the inability to deduct capital losses would make a TFSA "particularly inappropriate as an investment vehicle."
Rubin also said if the TFSA was the Tory government's attempt to make good on its 2006 promise to eliminate capital gains taxes if the proceeds were reinvested within six months, it was a "pretty pale response."
"It'll be very sellable until people actually figure out what the savings are to them," he told CBC News.
That's why many experts say the biggest benefits will go to the longer-term savers. "I'd say 10, 15, 20 years or more," accountant Tim Cestnick of The WaterStreet Group said. "It's the tax-free compounding over that period of time where you're really going to benefit."
Some analysts said the program just might not attract enough attention. "While a step in the right direction, the program may be too modest to be cost-effective and have a meaningful impact for Canadians," said Michael Conway, president of Financial Executives International Canada.
"Too modest to be cost-effective" raises an obvious question. Will your bank, credit union, brokerage firm, or mutual fund company charge to set up or administer a TFSA? No word on that yet.
RBC economists have a different criticism. In their analysis, Paul Ferley and Derek Holt argue that TSFAs are much more likely to be marketed to — and used by — middle- and upper-income earners, not by lower-income earners.
They also question whether TFSAs will really boost the overall savings rate. "One likely outcome is that contribution room may well be used up by gradually sweeping non-tax sheltered savings across to this new tax sheltered account and thereby have no material impact on saving tendencies," they write.
Montreal accountant Puneet Mehta, of the firm Mehta, Koppes, notes that a TFSA can generally hold the same kinds of investments as an RRSP. "However, a TFSA will not be allowed to hold investments in any entity with which the individual does not deal at arm's length, including an entity of which the individual is a 'specified shareholder' (generally a 10 per cent or greater interest)," he said. That restriction doesn't apply to RRSP investments.
In any event, the impact on the federal treasury — at least in the first few years — will be negligible. In the 2009-10 fiscal year, the estimate of foregone tax revenue is only $50 million. Twenty years into the program, once TFSA assets have grown to a substantial size, Ottawa estimates the program will cost $3 billion a year. That's half the revenue impact of a one percentage point cut in the GST.
Have TFSAs been tried before?
Not in Canada. But similar programs are already flourishing in Britain and in the United States. In Britain, they're called Individual Savings Accounts, or ISAs, and they've become a popular place to park cash. People can invest up to 7,000 pounds ($13,650) a year in an ISA, with no more than 3,000 pounds ($5,850) of that in cash.
In the U.S., they're called Roth IRAs — a program that was set up in 1997. Roth IRAs are more restrictive than TFSAs because they're designed as retirement vehicles, but the broad rules are the same. The maximum annual contribution varies by age. Currently, someone over 50 can put up to $6,000 a year into one of these accounts. More than 17.3 million American households now have Roth IRAs, according to the Investment Company Institute.
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