Tax-sheltered accounts are not being used to their full capability.
By: TERRY CAIN
Date: July 24,2014
The tax-free savings account (TFSA) is one of the most effective tax-saving programs the Canadian government has ever offered. Some call it the single best financial tool available for individuals.
But the truth is the vast majority of Canadians aren’t using it to its full capability. And there are rumblings Ottawa could soon put limits on the program.
TFSAs were introduced by then-Finance Minister Jim Flaherty in the 2008 federal budget. The concept is simple: Individuals set up a registered TFSA at their bank or broker. They then place funds into the account, up to an annual limit. A variety of investment vehicles can be placed inside – everything from a simple high-interest savings plan to individual stocks.
And, most importantly, the funds grow tax-free.
Investors will note key differences between TFSAs and registered retirement savings plans (RRSPs). Unlike with RRSPs, there is no immediate tax “refund” for contributing to a TFSA. However, there is also no tax payable when funds are withdrawn – and no restrictions on when withdrawals can be made.
With RRSPs, when funds are withdrawn they are taxable as regular income. As well, if funds are withdrawn before retirement, individuals have to repay the tax refund they received by making the initial RRSP contribution.
Craig Strachan, vice-president and head of product at Fidelity Investments, says the TFSA is usually used either for retirement savings or a short-term savings “parking spot.”
If the account is being used for the short term, then fixed income or cash equivalents are the best options to put into the account, Mr. Strachan says. He notes that equities are too volatile in the short term – the risk is too great that some of the principal will be lost over a short time horizon.
However, the strategy is flipped if the TFSA is being used as retirement savings. “You get the benefit of tax-free compounding, and not paying taxes when you withdraw,” says Mr. Strachan. “So you want to invest in vehicles that are proven to grow the most over a longer time horizon – and that is equities.”
Lorn Kutner agrees with this distinction. Mr. Kutner, who is a partner specializing in private company services at Deloitte, says he’s a “big believer” in using a TFSA to save for short-term goals such as buying a new car, taking a trip or as an emergency fund.
As far as which investments to put in a TFSA, Mr. Kutner notes that interest income is taxed at a higher rate than dividends or capital gains, so you benefit more by keeping them in a TFSA compared with another account. However he also points out that with interest rates currently so low, you may get a better financial result keeping stocks, mutual funds or exchange-traded funds in your TFSA.
One more factor to keep in mind when using TFSAs is the annual contribution limit. The limit began at $5,000 and has now risen to $5,500. Unused contribution room can be carried forward to future years, though the cumulative limit for someone who has never contributed cannot exceed $31,000.
However, one of the biggest uncertainties about the future of TFSAs is whether the annual and cumulative contribution limits may change. At one point the Conservative government had proposed to nearly double the TFSA contribution limit to $10,000 once the deficit was eliminated. The government did not mention any proposed increases in its most recent budget.
In fact, the Finance Department estimates TFSAs are already costing the federal government more than $400-million in tax revenue. While there would be a political cost, restrictions or limits on the program could be a tempting way for Ottawa to help balance the books.
Contributors tend to make common mistakes with TFSAs. One is using the account to save for a child’s education. The registered education savings plan (RESP) is intended for this purpose – and has the added bonus of matching contributions by the government.
Another common mistake is simply leaving contributions in a low-return savings account, rather than using investments that are likely to yield higher returns. However, investing directly in stocks in a relatively small-value account like most TFSAs can lead to challenges when it comes to diversification. Mutual funds can often be a good solution to this problem.
And while most individual investors may be able to choose an appropriate mutual fund on their own, a financial advisor may also help. However, an advisor can help in a more basic – but even more important – way. “They have a strong incentive to encourage you to contribute to your TFSA, and your other investment accounts,” says Mr. Strachan.
“The most important factor is making sure you do put something in, and they are the ones to get people to keep putting money aside. Savings is the most important thing, and every vehicle helps.”