New tax-free account means there's planning ahead

PORTFOLIO STRATEGY

New tax-free account means there's planning ahead
Rob Carrick's ideas for managing your investments
Headshot of Rob Carrick

ROB CARRICK

March 1, 2008

In the financial world, people who use savings accounts, guaranteed investment certificates and bonds are second-class citizens.

The Tax-Free Savings Account introduced in the federal budget this week goes a long way toward eliminating this bias. For many people, this will be the new program's chief benefit when it kicks in starting in 2009.

From a tax point of view, there is no distinction between money earned through salary and the interest paid by GICs and the like. Dividends and capital gains both get special treatment that allows their after-tax returns to crush those from anything paying interest.

TFSAs are an investing equalizer. No matter what you put in it, and you can invest in all the same things as you can with an RRSP, you don't pay tax on your gains. Nor is there any tax to pay when you withdraw money from a plan.


The Globe and Mail

All of this highlights the fact that investors have some planning to do in the lead-up to the introduction of this new program next year (the usual proviso for minority governments applies, of course). To start with, TFSAs are ideal for interest-paying savings and investments.

If all your investments are tied up in your registered retirement savings and education plans, then a TFSA will be a perfect receptacle for your short-term savings and emergency funds. You'll want to use a high-interest savings account from the likes of President's Choice Financial, ING Direct, Manulife Financial, ICICI Bank of Canada, Royal Bank of Canada, Bank of Nova Scotia, Citizens Bank of Canada, Canadian Tire Bank and more. Regular bank savings accounts are pointless in this or any other application because they pay only trace amounts of interest at best.

Critics of the TFSA point out that the tax benefits are small if you use even high-interest accounts for savings. An Alberta resident who earns $75,000 a year might pay all of $72 in tax on $5,000 invested a 4-per-cent high-rate savings account for a year. Still, it's a no-brainer to use a TFSA to protect that $72.

People with investments outside their registered plans need to think strategically about how they'll use TFSAs. Again, though, interest-paying investments look like a top candidate for inclusion in these plans.

On reading the budget this week, Kevin Dancey, president and CEO of the Canadian Institute of Chartered Accountants, immediately singled out strip bonds as being an ideal TFSA investment. Strips are bought at a discount to their value at maturity, and the differential is computed into an annualized yield. You don't actually get the usual interest payments each year with a strip, but you'll pay tax as if you did. Not in a TFSA, though.

David Shymko, a financial adviser in Vancouver with Macdonald, Shymko & Co., said he sees TFSAs primarily as a tool collecting interest income. "Dividends would be wasted in there, just as they're wasted in registered accounts."

A well-hidden budget provision will slightly raise personal income tax rates on dividends starting in 2010, but your marginal tax rate on dividends (that's the tax rate on your last dollar earned) can in some cases be much less than half of what it is for interest income.

TFSAs and investing for dividends and capital gains aren't necessarily incompatible, however. It all depends on how extensive your non-registered investments are. If you have a large, diversified portfolio, you'll want to keep interest-paying investments in the TFSA and your stocks outside. If you have small non-registered holdings, it can make sense to consolidate in a TFSA and let the portfolio ride for the long term. When you finally get around to withdrawing funds from your plan, the taxes you avoid could be significant. Quite likely, they'd outweigh the benefits of using a TFSA for interest-paying investments only.

The most notable feature of the TFSA may be its utility for virtually every demographic above the age of 18. For example, seniors are expected to be avid users. First, they'll be able to save or invest any surplus funds from their registered retirement income fund withdrawals in a tax-sheltered format. Second, any money they pull out of a TFSA won't affect their income in a way that negatively affects their eligibility to receive Old Age Security and other government benefits.

There are a couple of tax wrinkles with TFSAs that will lessen their appeal to aggressive stock traders.

In a conventional investment account, you can get some use out of your dud stocks by applying losses against taxable capital gains. Capital losses in a TFSA are wasted. There's also no point in using borrowed money to invest in a TFSA because you won't be able to deduct interest costs like you can in a regular investment account.

Investors with existing non-registered savings and investments may be wondering how they can get these assets into a TFSA. If you transfer stocks or mutual funds over, it's considered a sale and you'll be liable for taxes on any applicable capital gains. GICs will be tricky because they're not a liquid asset.

"We honestly haven't gone into those kinds of issues yet," said Linda Knight, president of BMO Mutual Funds. "The reality is, people who have non-registered savings and investments now are going to want to use this vehicle. So we'll look at how to make that transfer as advantageous and easy as possible."

Another issue that still needs to be resolved is whether financial institutions will charge annual administration fees on TFSAs, just as they do with RRSP and RESPs. "Even if they get $10 or $15 registration fees, this will be a nice program for the banks, or other financial institutions," Mr. Shymko said.

Regardless of how you plan to use a TFSA, don't open one before you check the fees. There are bound to be some no-fee TFSAs offered and they're the ones that will be most attractive.

Taxes and the TFSA

Starting in 2009, the new Tax-Free Savings Account will allow you to invest $5,000 a year without paying taxes on your gains or your withdrawals. What investments should go in a TFSA? One way to decide is to look at how much of a benefit you'll get from the tax sheltering provided by a TFSA.
Marginal tax rates on investment income ('07 tax year)
TFSA Non-Registered (%)
B.C. resident making $50,000 per year
Interest income 0 30.7
Dividend income* 0 4.4
Capital gains 0 15.3
Ontario resident making $100,000 per year
Interest income 0 43.4
Dividend income* 0 20.3
Capital gains 0 21.7
Nova Scotia resident making $150,000 per year
Interest income 0 48.3
Dividend income* 0 28.4
Capital gains 0 24.1

*applies to eligible dividends paid by corporations; also, taxes on dividends will rise slightly starting in 2010

SOURCE: ERNST & YOUNG TAX'S ONLINE 2007 PERSONAL TAX CALCULATOR

*****

TFSA ABCs

Basic concept: A vehicle for tax-free savings and investment available to anyone 18 and older.

Start date: 2009

limits: $5,000 per year to start.

Tax on gains: Nil

Tax on Withdrawals: Nil

Deductions: Nil

Unused Contribution: Available to carry forward.

Funds Taken Out: Withdrawals are added back to your total contribution room.

Allowable Investments: Same as RRSPs, which means stocks, bonds, funds and savings accounts.