TFSAs have their advantages and pitfalls

What's the most dangerous thing about the tax-free savings account?

It has no contribution deadline.

What I mean is if you miss this year's contribution, there's no problem. Your unused room simply carries forward to the next year. And so on, and so on... which can encourage people to be complacent about their saving programs and miss out on tax-free compound growth.

Although unused RRSP room also carries forward, at least the RRSP has a deadline, related to the deduction on the current year's tax return.

By the way, the deadline this year for RRSP contributions deductible on your 2011 income tax return is Feb. 29. Since the TFSA does not provide a tax deduction, there's no deadline for TFSA contributions.

But let's look at some of the benefits and advantages to using a TFSA for your retirement planning, and see if we can motivate you to fully fund your plan to its limit.

The TFSA began in 2009, which makes 2012 its fourth year. That means everyone who was 18 and held a valid social insurance number in 2009 can now have contributed up to $20,000, including the 2012 contribution.

The biggest advantage to a TFSA is any investment income earned by investments inside your plan are not taxed, either now or on withdrawal. While an RRSP provides the same tax sheltering while money stays in the plan, every dollar that is withdrawn is fully taxable.

As well, RRSP and RRIF withdrawals also add to the "net income" line on your tax return. This can negatively affect income-tested government programs, including the guaranteed income supplement, various tax credits and eligibility for old age security.

TFSA withdrawals have no such negative effect, which is one reason people are increasingly turning to the TFSA as an attractive retirement savings vehicle.

It has appeal to people who project both high and low incomes in retirement. High-income earners will avoid taxes and potential OAS clawback, while low-income earners might avoid losing out on the GIS, GST tax credit, age amount, or potentially the Canada Child Tax Benefit or employment insurance benefits.

Another nice thing about using the TFSA as the safe harbour for your savings is the contribution room is reinstated in the year following a withdrawal. Therefore, it has much more flexibility than the RRSP. If you run short of money, you can withdraw any TFSA amount without paying tax, and then redeposit the same amount after the following Jan. 1.

Alternatively, if you want to avoid a withdrawal for a temporary cash need, the TFSA can be used as collateral for a loan, unlike an RRSP. The flip side of this is a TFSA does not provide any creditor protection in the event of bankruptcy.

Your investment options are very broad, with the same guidelines as an RRSP. This means you can use guaranteed vehicles, like savings accounts, GICs or government savings bonds, or move into mutual funds that invest in savings vehicles and also corporate bonds or stocks. If you have a plan established with an investment dealer, you can also purchase individual stocks and bonds, income trusts and other options.

Some people use the TFSA as a place to shelter tax they would otherwise pay on their cash reserves, investing conservatively.

The opposite approach is the "home-run" strategy, attempting to maximize tax-free capital gains and dividends on equity investments. This worked well for a lot of our clients, since early 2009 was the bottom of the market, and adventurous souls could then purchase good quality investments cheaply. Many have doubled in value since then.

Like any new vehicle, the TFSA still suffers from a lot of confusion and misinformation, but the rules become straightforward if you read a bit about them. Do yourself a favour and spend a bit of time, and you'll see a lot of advantages.

Next week, we will review the rules and best strategies for RRSPs, to give you some time to plan before that deadline.

David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).

dchristianson@wellwest.ca

Republished from the Winnipeg Free Press print edition January 6, 2012 B10