January marks the start of that time of year when financial institutions redouble their efforts to convince Canadians to save for retirement by contributing to their RRSPs. The season's complexion has changed noticeably since tax-free savings accounts arrived on the scene four years ago. Now, the conversation is as likely to involve TFSAs as RRSPs, and with good reason. The TFSA is one of the few legal tax-avoidance schemes available to virtually all adult Canadian residents.
Since 2009, eligible adults have been able to contribute up to $5,000 (after-tax dollars) each calendar year to a TFSA and pay no tax on the profits earned. For 2013, the federal government has raised the contribution limit to $5,500. The extra $500 is the first inflation adjustment since the program started.
If you have faithfully maximized your contribution every year in January since TFSAs launched in 2009, your nest-egg should be well north of $20,000. Assuming a 5% return from a mix of stocks and fixed income, your profit to date would top $2,500. At a marginal tax rate of 30%, you have kept more than $700 from reaching Canada Revenue Agency coffers.
Besides the straight tax savings, there is much to like about a TFSA. You do not need earned income to contribute to a TFSA, as you do with RRSPs. Another advantage of TFSAs is that money can be withdrawn at any time and the entire amount re-contributed the following year.
If your finances are tight, you can contribute less than the maximum in a particular year and carry forward any unused TFSA contribution room to future years.
Despite its name, a TFSA is not just a savings account at your local bank or credit union. A TFSA issuer could be a mutual-fund dealer, a trust company, a discount or full-service broker or an insurance company.
Acceptable investment choices include cash, GICs, bonds, stocks, mutual funds, exchange-traded funds and even certain shares of small-business corporations.
The best choices for a TFSA are highly taxed investments. They include interest-generating fixed-income securities, real estate investment trusts (REITs) with fully taxable distributions, and foreign blue-chip stocks that pay dividends.
You can move funds from one TFSA account to another by completing a direct transfer form available from the receiving TFSA issuer. If you withdraw and re-deposit the funds yourself, the transferred amount will count against your annual contribution limit and you will pay a penalty of 1% per month on any over-contributions.
Given its flexible design, a TFSA can be a useful savings vehicle, no matter your stage of life. Everyone needs an emergency fund, an easily accessible hoard of cash to cover expenses in unexpected situations such as losing a job or a dead furnace in January.
Those on a tight budget with no other cash to invest could stash their emergency funds in a savings-account type of TFSA such as the ICICI Bank TFSA, which currently pays 1.8%. The money would be available if needed, and any interest earned is sheltered from the taxman.
Students could use a savings-account TFSA for their summer job earnings and withdraw the money for school expenses later in the year. Again, any interest income is not taxed.
A young professional with money to invest, no family obligations and a long time horizon could use a TFSA as an investment vehicle and avoid taxes on all profits made over time. In this case, opening a TFSA at a full-service or discount brokerage is the preferred route since it provides the full range of investment choices including higher risk/higher reward assets such as stocks and REITs.
For working Canadians, a TFSA can be a useful method for saving money for a major purchase such as a new car or the down payment on a house. To ensure that the funds are there when you need them, the money should be invested conservatively. You will save the tax owed at your marginal tax bracket when you withdraw the money to make the purchase.
A key feature of the TFSA is that neither income earned within the plan nor any withdrawals will affect eligibility for income-tested government benefits and credits.
For people close to retirement who have little or no savings or pensions, a TFSA is an ideal savings vehicle because withdrawals do not affect eligibility for the Guaranteed Income Supplement (GIS) for low-income seniors.
Some well-off seniors who receive Old Age Security find that their considerable income pushes them into OAS clawback territory. This often happens at age 71 when an RRSP must be converted to a registered retirement income fund (RRIF) and regular mandatory distributions begin. Funnelling excess income into a TFSA will keep the profits this money produces from further reducing their OAS.
Empty-nesters planning for retirement may decide to channel some of their savings into a TFSA instead of an RRSP in order to avoid future compulsory RRIF withdrawals that raise their income to OAS clawback levels.
To sum up, TFSAs deliver outstanding savings and tax-avoidance benefits at all stages of adult life. A TFSA should figure in the financial plans of everyone who qualifies.