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Take Advantage of TFSA Versatility
In: Timely Opportunities


  A Multiple Use Tool

 

The recent misunderstandings regarding contribution limits on Tax-Free Savings Accounts (TFSAs) have been capturing financial headlines, but the confusion is no reason for investors and savers to avoid them. They can play a major role in your overall financial planning.

A critical element in the use of these accounts, and the one that has caused so much confusion -- not to mention

 A Canadian Conundrum

   Some 70,000 or more taxpayers seem to have been caught up in the confusion over TFSA contributions and transfers.
    The rules are fairly straightforward: If you are older than 18 years of age, you can open an account and contribute $5,000 in a single year. Unused contribution room is automatically carried forward. Withdrawals increase your available room, but you cannot use that extra space until the start of the following calendar year.
    So, if you contributed the maximum $5,000 on Jan. 1 2009, when the accounts first became available, withdrew $4,500 in March and replaced it in April, you overcontributed $4,500. That means you will have to pay a one per cent penalty tax for each of the nine months the money is in the account during the remainder of that year because the additional contribution room wasn't available until Jan. 1, 2010. You will owe $405 (one percent times nine times $4,500).
  The one per cent penalty is only for non-deliberate overcontributions. If the contributions are deliberate, there is an additional penalty of 100 per cent of any income or gains resulting from the overcontribution.
   There has also been some misunderstanding of how to make transfers between TFSAs. If you have more than one of these accounts, you can make a direct transfer from one to the other without tax consequences. However, if you withdraw funds from one TFSA and contribute those same funds to another TFSA, the transactions will affect your contribution room limit and you may be subject to tax on excess contributions.
    The good news is that the CRA is reviewing each of those assessments with an eye toward waiving the penalty for taxpayers who genuinely misunderstood the rules. Individuals have until Aug. 3 to plead their case. If you are one of these taxpayers, talk to your accountant to discuss your options.

 Under the legislation governing TFSAs, the Finance Department can waive or cancel all or part of the tax penalty if you can persuade the government that the liability was the result of "reasonable error" and you act "without delay" to remedy the problem.
potential tax penalties -- is also one of the benefits of TFSAs: The tax-free money withdrawn from them opens up contribution room, but not until the following year. This created problems for taxpayers who used their TFSAs like a bank accounts, making withdrawals and topping up the accounts in the same year. (See right-hand box.)


Studies appear to indicate that Canadians need to seek advice about how to use these accounts. According to one survey:

  • Only 41 per cent of respondents knew you can hold a broad range of investments in a TFSA;
  • Just 36 per cent knew that you didn't lose contribution room if you didn't use it all in one year;
  • A mere 22 per cent realized that you can own more than one account; and
  • Just 43 per cent knew that contributions to the accounts are not tax deductible as they are with Registered Retirement Savings Plans (RRSPs).

Although there is no tax deduction, withdrawals are tax free and the returns generated through interest, dividends or capital gains are not taxable, except for foreign taxes on foreign investments.

In addition to a place to park your cash, TFSAs can play vital roles in your long-term wealth-building plans. Think of them as another asset to go along with your principal residence and life insurance policy.

Here is a look at some of the ways you can use TFSAs to help accumulate wealth for you and your family:

Tax-Free Investment Accounts

You can invest your TFSA contributions in stocks, bonds and other financial assets, including short-term deposits and GICs. Bearing in mind that, unlike the TFSA, registered retirement plan withdrawals are taxed, you may consider keeping fixed income instruments in your RRSP or Registered Retirement Income Fund (RRIF). High-growth investments that may produce large capital gains could go into a TFSA to protect them from taxes.

For example, five per cent preferred shares purchased at $20 will grow to $25 eventually and pay $1.25 a year in taxable income. An RRSP will shelter that income, but only until it is withdrawn. If those securities are kept in a TFSA, there is no income tax on any of the withdrawals and the value of the account grows just as much as the value of an RRSP would. On the other hand, capital losses inside a TFSA cannot be deducted, and dividends earned inside a TFSA do not generate dividend tax credits.

Think carefully before transferring undervalued securities into your TFSA. If you trigger a capital loss, the in-kind stock transfer will be denied as a superficial loss. Talk to your adviser about whether it would be better to sell your losing shares and deposit the proceeds into the account.

While you are planning, remember you can tap TFSAs for emergency or other uses, so you may want to keep some short-term, liquid, interest-bearing investments in the accounts. 

Income Splitting

You or your spouse or common-law partner can contribute to each other's account. So, if you have a lower-earning spouse or partner, you can contribute the 2010 amount of $5,000 to both accounts and the income earned from your spouse's account won't be attributed back to you. Conversely, if you contribute to a spousal RRSP, income attribution rules do apply.

During retirement, there could be enough money in the accounts to provide flexibility in how taxable withdrawals are taken from other accounts and pensions in order to minimize the household tax bill.

The spouse or partner who gets your contribution has a choice of several productive options. For example, the individual could pledge the TFSA as collateral for a loan to make investments. All the non-taxable income from the investments would belong to that spouse, and the interest charges on the investment loan would be tax deductible.

Estate Planning

You can name a beneficiary to your TFSA. If that is what you decide to do, you have two choices:

1. Name your spouse or common-law partner the successor holder. The account, but not your remaining contribution room, will transfer tax-free to the surviving spouse. The transfer will not affect the contribution room of the spouse's account. A transfer will prevent your estate from having to pay probate fees on the funds.

2. Name a designated beneficiary. This can be anyone you choose. The person named receives the proceeds of your account either in cash or in kind and the TFSA will no longer exist. Only income earned in the account before your death will be tax-free. Earnings after the date of death will be taxable to the beneficiary. This strategy also avoids probate fees.

If you do not name a beneficiary, the proceeds of the account will be paid out to your estate.

Talk to your accountant, who can come up with other ideas on how to make the most of your TFSAs as you build wealth and plan your estate.

In Issue: July 21st, 2010 RLB LLP