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A free lunch?

TFSA often misunderstood, but make no mistake, it will lead to substantial savings -- so long as you actually use it

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A little more than five years ago, the tax-free savings account was announced in the 2008 budget with very little fanfare.

Each Canadian adult's opportunity to contribute $5,000 of after-tax money a year to an investment account that could grow tax-sheltered and be withdrawn without taxation didn't seem like that big a deal, especially when it didn't take effect until Jan. 1, 2009.

Yet in the world of finance, where most so-called free lunches come with a price, the feds were actually tossing wage slaves a veritable brown-bagger.

Still, the TFSA's official launch almost got lost in the headlines due to the collapse of the stock and credit markets at the time. Few people had the stomach for investing at the end of 2008 -- even though it was precisely the right time to put money into a TFSA.

"If someone had opened a TFSA and bought some blue-chip stocks at the bottom of the market in those first three months, they would have made big gains in their TFSA within the span of about 10 months," says personal finance expert Gordon Pape.

Pape has authored the only comprehensive book on TFSAs, Ultimate Tax-Free Savings Account Guide, and he rushed to launch it just in time for the 2009 start date for TFSAs.

More than four years later, few Canadians don't know about TFSAs.

Still, some could benefit from perusing the book, because a good number of misconceptions exist about the savings vehicle.

"The biggest misconception is the name -- tax-free savings accounts -- because that leads people to think these are like bank savings accounts, and they don't understand the range of different types of securities you can hold in these plans, depending on the type of plan you open," Pape says.

"If they had been called tax-free investment accounts, then I think people would have started looking at them in a different way."

While there is no truly wrong or right way to use a TFSA, there's no denying its long-term benefits for growth.

Today, Canadians can have contributed as much as $25,500 to a TFSA. And we get to contribute another $5,500 per year until annual inflation adjustments increase the annual rate by another $500. Or, as Prime Minister Stephen Harper suggested while stumping in the last election, the annual contribution rate will be doubled to more than $10,000 a year once the budget deficit has been slain.

RBC personal financial planner Ryan Lussier says his preference when advising clients to contribute to their TFSAs is to invest in more aggressive assets.

"The reason being is your tax advantage is not that great if you're holding conservative interest-bearing investments like savings deposits or GICs that are only yielding one or two per cent returns."

On $25,500 earning three per cent a year, the tax savings are about $356 -- at the highest marginal rate. Certainly that's not chump change, but the long-term growth potential is in much more rewarding stock market investments.

Even a dividend mutual fund providing three per cent returns from dividends and four per cent capital gains annually offers a more wallet-fattening proposition.

The tax savings are about $484 at the highest tax rate annually, but over time, the money has the potential to grow into a much larger pile much more quickly.

"The best tax savings that you can generate are capital gains; even though 50 per cent of capital gains are not taxable, the other 50 per cent are fully taxable at your marginal rate," Pape says.

"But that doesn't mean going out and gambling on penny stocks."

The obvious risks with penny stocks aside, the one TFSA pitfall some investors may not realize at first is that just like RRSPs, any capital losses inside a TFSA cannot be used to offset taxes paid on capital gains realized in a non-registered investment.

But blue-chip stock -- big companies with steady dividend track records -- are generally a good investment for a TFSA because they pay you to hold them, and they generally go up in value over the long haul, he says.

"If you really wanted to go for the big kill and this was money you could afford to lose, you could look at investing in something like a mutual fund that specializes in junior mining stocks, which are way down in the dumps right now," Pape says. "They're cheap, and history has shown us that when the cycle turns and commodity prices start to go up, the prices of these types of stocks go up disproportionately."

But your choice of investments for a TFSA really boils down to your risk profile, says Sara Kinnear, a lawyer specializing in tax and estate planning at Investors Group.

"You may have some of the money in your TFSA devoted to short-term objectives and some of it for long term."

She adds the biggest dilemma for most people is whether they should save in an RRSP or a TFSA.

"That depends on a lot of issues, like what your tax rate is right now and what your expected tax rate will be in retirement, how long you're going to leave the money in there, and all that kind of stuff," she says.

"If you've already maximized your RRSP limit -- or maybe because you don't have one because you're not working or you have big pension adjustments -- then absolutely you should put your savings into the TFSA."

Lussier says people should get a little professional tax advice to figure out what makes the most sense for them. But the majority of people should focus on RRSP contributions first because they help reduce taxes today, providing an immediate return on investment -- and when done properly, those contributions will lead to real tax savings in retirement. That's because you defer paying higher taxes now and withdraw the money at a lower tax rate in retirement.

But there are exceptions to the RRSP-before-TFSA rule. For instance, low-income earners expecting to be low-income earners in retirement may want to put whatever savings they can find in a TFSA because an RRSP withdrawal could affect income-tested government financial aid such as the guaranteed income supplement and the GST rebate, whereas a TFSA withdrawal has no effect on either one.

Yet if you can afford to maximize contributions to both accounts, you're robbing yourself of an opportunity to avoid taxes entirely on investments later in life by failing to stuff a TFSA full of cash.

"I see us getting to a point in time where most of the money people have invested will be tax-sheltered either in an RRSP or a TFSA," says Pape. "Either that or they won't know what they're doing."

Quick facts

Too much of a good thing?

At some point, Canadians are going to have a substantial amount of contribution room for their TFSAs. And like personal finance author Gordon Pape mentioned, between RRSP and TFSAs, most folks should be able to tax-shelter all their savings. In fact, some experts have pointed out the federal government stands to lose a substantial amount of tax revenue from investments inside TFSAs that otherwise would have been held in non-registered accounts where their earnings are taxable. In 2012, economist Kevin Milligan authored a report in the Canadian Tax Journal that estimates when TFSAs have about $200,000 in contribution room in less than two decades, 80 per cent of all taxable assets would be sheltered, resulting in a six per cent reduction in government revenue from income taxes. So far, estimates on the TFSAs' effects on tax revenues have been minimal, he writes. According to the Tax Expenditures and Evaluations Report, estimated lost tax revenue is about $220 million.


Beware of over-contributing:

Most people aren't going to put more into their TFSA than the annual limit, but where many have had their hands bitten by the CRA is when they have inadvertently over-contributed. This generally happens when they first withdraw money from their TFSA, then recontribute that money during the same tax year, says tax expert Sara Kinnear with Investors Group. "Let's say, for example, I've maxed out all my prior-year limits, so I have a contribution for this year of $5,500." She contributes $5,500, then withdraws $5,000. "That's fine so far, but then next month I get a bonus from work of $5,000 and I think, 'Why don't I put that in my TFSA?' I can't do that because I've already maximized my limit for the year." If she did make than additional contribution, she would be $5,000 over the limit and subject to a penalty tax of one per cent per month. That's $50 a month, so if that over-contribution was made in June, the tax bill could be $300. Furthermore, any gains made on the over-contributed money inside the TFSA are fully taxable. But if she waits until 2013, she can make her annual contribution of $5,500, then recontribute $5,000 without penalty.


TFSA vs. RRSP: In most cases, it makes sense to contribute to an RRSP over a TFSA if you're looking for the best place for your money to grow, but there are exceptions, such as low-income earners. RBC financial adviser Ryan Lussier says other situations where people may want to invest in a TFSA over an RRSP is when they have a large work pension. In this instance, they may be looking at substantial pension income from work, CPP and OAS that when combined with a taxable RRIF withdrawal, may push their net income into the OAS claw-back range. On any dollar of net income above the $69,522 limit, you are clawed back 15 per cent. Lussier says business owners and farmers may also want to favour TFSA contributions over RRSPs because they can have very low taxable incomes while working as a result of deductions, and then they can be faced with a much higher income in retirement if they are able to sell their business. "When they sell the business or the farm, they're in the highest marginal tax bracket and have a lot of investment income without many tax deductions to use against it." So a source of non-taxable income would certainly be a good thing.

Republished from the Winnipeg Free Press print edition March 30, 2013 B10

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