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How the 'TIFSA' can be your tax free nest egg

Jonathan Chevreau, Financial Post Published: Tuesday, February 26, 2008

OTTAWA -- Canadians can shelter an extra $5,000 a year from taxes [$10,000 for couples] through the new Tax-Free Savings Account (TFSA) unveiled in Budget 2008. The TFSA was the headline grabber in the budget and some practitioners are already pronouncing it "TIFSA."

True, it's not the deferred capital gains break the Conservatives promised before they first won power, but the TFSA will be a welcome addition to an all-too-short list of tax shelters when it becomes available in 2009.

Unlike RRSPs, there is no upfront tax deduction, but the proceeds are not taxed when the money is withdrawn. If all this sounds familiar, that's because it should. The TFSA is a new name for what the C. D. Howe Institute once dubbed "Tax Prepaid Savings Plans" or TPSPs. And in 2004, while the Liberals still ruled, the Conservative party proposed a similar vehicle under the name Registered Lifetime Savings Plans (RLSPs).

TFSAs, TPSPs and RLSPs all resemble the Roth IRAs in the United States, although Roth IRAs are more focused on retirement and have more constraints and penalties imposed on early withdrawals.

Canada's new TFSA is flexible enough for consumption and retirement. Having paid income tax to earn a certain sum in the first place, any net proceeds placed in the TFSA will be totally tax free from that point on.

So interest income will compound tax-free, while capital gains or dividends generated by stocks are also tax-free. When withdrawn from the plan, the full nest egg is available tax-free. Plus, the withdrawal frees up a comparable amount of new contribution room. As the budget puts it, there is "full flexibility to withdraw and recontribute."

The TFSA is designed to help Canadians save for serial short-term consumption goals like automobiles, vacations or home renovations. But it can also be used to save up for a down payment on a home or for education.

While not focused on retirement, the TFSA is also attractive to low-income seniors -- the tax-free withdrawals won't trigger reductions in Old Age Security benefits or the Guaranteed Income Supplement. Nor does it impact income-tested benefits like the Canada Child Tax Benefit.

While the measure appears to come late in the game for the boomer generation, the TFSA will still come in handy, particularly for boomers who intend to work another decade or two.

Unlike RRSPs, which must be collapsed after age 71, there is no age limit for contributing to a TFSA. Unused contribution room is carried forward indefinitely. The initial $5,000 contribution amount will be indexed to inflation.

High-income investors can use the TFSA to shelter highly taxed interest income or foreign dividends, which are otherwise taxed at the top marginal tax rate.

Like RRSPs, TFSA holders can name spouses or common-law partners as beneficiaries and rollover the proceeds to them upon their death. But unlike RRSPs or RRIFs, on the death of the second party, the proceeds are NOT taxable. That means children will be able to inherit the total amount tax-free, says Jamie Golombek, vice president of tax and estate planning for AIM Trimark Investments.

And as with spousal RRSPs, spouses or common-law partners can contribute to their partner's TFSA.

Golombek says the TFSA will be another effective way for couples to split income for tax purposes. The so-called "attribution rules" will not apply to income earned in a TFSA, the budget documents say.

Given the additional complexity, TFSAs should be a boon to the financial industry: they can be issued by any institution that issues RRSPs. Financial advisors should welcome this new savings vehicle since it gives them one more tool to add to their mix of investment recommendations.

TFSAs can hold the same investments as RRSPs, such as mutual funds, stocks, bonds and GICs.

As with RRSPs, those who borrow to fund TFSAs will not be able to deduct the interest for tax purposes.

For those in the highest tax bracket, mathematically the TFSA and RRSP are almost a wash, Golombek says.

A chart on page 278 of the budget notes the tax treatment on the TFSA is the mirror image of that provided on RRSPs. Thus, RRSP contributions are tax deductible, with both the contributions and the investment earnings taxable upon withdrawal. By contrast, TFSA contributions are made from after-tax income and both the contributions and the investment earnings are exempt from tax upon withdrawal.

The budget says "the net after-tax rates of return on TFSA and RRSP savings are equivalent when effective tax rates are the same at the time of contribution and withdrawal." That is, the value of the tax deduction from RRSP contributions is equivalent to the value of withdrawing funds tax-free from a TFSA.

But one thing is certain: the TFSA is better than nothing, which means its tax treatment is better than what investors get in non-registered investment portfolios. The budget confirms this: "The rate of return from saving in either a TFSA or an RRSP is superior to unregistered saving."

Ideally, one contributes to both. However, low-income earners who must choose between the TFSA or the RRSP may prefer the TFSA if they plan to benefit in old age from the OAS, GIS or other means-tested government programs.

Some older investors tempted to "melt down" their RRSPs as they approach 65 may opt to move the proceeds into TFSAs in order to minimize the OAS clawback and other government benefits.

As with RRSPs and RRIFs, there is no foreign content limit on the TFSA, so it would be ideal for holding foreign dividends as well as interest-bearing investments. Foreign dividends are taxed like interest for Canadians because they don't qualify for the dividend tax credit generated by Canadian publicly traded companies.

The budget also proposes to adjust the dividend gross-up factor and Dividend Tax Credit rate for eligible dividends to reflect the corporate tax reductions in the 2007 Economic Statement.

The other significant measure, on page 82, is increased flexibility for locked-in pensions such as Life Income Funds. In line with some provincial moves to loosen up access to locked-in funds, the budget says individuals 55 and over can get a one-time conversion of up to 50% of LIF holdings into a tax-deferred savings vehicle with no maximum withdrawal limits. Those who are 55 or more with small holdings up to $22,450 can wind up the accounts and convert to a tax-deferred savings vehicle. Those facing financial hardship will also be able to unlock up to $22,450.