The Best Tax Solution Savings Accounts

This is the best article I have seen on Tax Free Savings Accounts.
I like them and think they are a lot better solution to savings and tax reduction than RRSPs. This article covers the topic very well
Dan White and

Learning module: A closer look at Tax-Free Savings Accounts
Roberta Wilton / November 06, 2009

Fall has always been the traditional time for Canadians to turn their attention to making their RRSP contributions. Since 1957, RRSPs have been the simple way for Canadians to save for their retirement and for many, the only way to receive a break on their taxes. However, the RRSPs lock on tax-advantaged savings ended at the beginning of this year with the introduction of the Tax-Free Savings Account (TFSA).

The TFSA has been called one of the most exciting financial planning and wealth management tools for Canadians since the RRSP. Given this lofty praise, it is essential for financial planners to understand the rules, regulations and benefits surrounding this new investment tool. To assist advisors, CSI has introduced a continuing education program that focuses on Tax-Free Savings Accounts called Understanding TFSAs.

What is a TFSA?
At its core, it is a savings account, but with a twist: Income earned within a TFSA will not be taxed throughout the holder’s lifetime. Unlike an RRSP, contributions are not tax deductible, but with a TFSA, there are no restrictions on the timing or amount of withdrawals, and the money that is taken out can be used for any purpose.

A TFSA is a good way to save for anything from tuition fees to a new house, and it is ideal to hold as an emergency fund. The appeal of the TFSA, besides the tax-free growth, is its flexibility. According to Understanding TFSAs, “…it can be of benefit through an individual’s entire adult life cycle.”

The Rules
The basic rules are straightforward. Any resident of Canada 18 or over can open a TFSA, and you do not have to earn any income to be able to contribute. Funds can come from a number of sources including gifts, inheritance, employment income and a tax refund. As of today, contributions are limited to $5,000 a year; however, after 2009, the amount will be indexed to inflation and rounded to the nearest $500. As for unused contribution room, according to Understanding TFSAs, “…whenever you don’t make the full annual contribution, you can carry forward that contribution room and use it any time in the future.”

Withdrawals from a TFSA can be made at any time, with no limits on the amounts or restrictions on use. Money taken out of a TFSA may be re-contributed (or replaced) in the next calendar year but does not have to be replaced, and the amount withdrawn will be added on to your contribution room for the following year. Also, there’s no deadline for re-contributing amounts withdrawn. This differs from an RRSP where money taken out under the Home Buyers’ Plan (HBP) or the Lifelong Learning Plan (LLP) must be repaid within a certain time period or else the amounts withdrawn become fully taxable.

There is a penalty for over-contribution (i.e., if you contribute more than your contribution room allows) of 1% of the excess contribution every month. On October 16, 2009, the federal government proposed amendments to the TFSA, under which any income reasonably attributable to deliberate overcontributions will be taxed at 100%.

Some other important rules from Understanding TFSAs:

• There is no penalty or tax on the money you withdraw from a TFSA.
• The money you contribute to a TFSA is not tax-deductible.
• There is no tax payable on the income earned in the TFSA, whether it be interest, dividends or capital gains.
• You can invest the amounts in a TFSA in a wide variety of products such as GICs, savings accounts, stocks, bonds or mutual funds.
• To be considered a TFSA, it must be registered with the Minister of National Revenue after it is set up. (The holder does this through the financial institution that issues the TFSA.) The deadline for registration is the last day of February in the year following the year in which it was set up.
• It must be one of the following types: a deposit, an annuity contract, or an arrangement in trust.
• Only the holder may make contributions, except in the case of an employer’s group plan. In that case, the employer is allowed to make contributions on behalf of the holder. (Those contributions are considered income for tax purposes.)

What can go in a TFSA?
Like RRSPs, there is a long list of “qualified investments” for a TFSA. Cash deposits, GICs, mutual funds, bonds and stocks are just some. For a full list of what qualifies and what does not, check with Canada Revenue Agency or CSI’s Understanding TFSAs.

Taxes and TFSA
Administration and investment counseling fees related to a TFSA are not tax-deductible. As well, interest on money borrowed to make TFSA contributions is not tax-deductible. Transferring previously owned stocks and bonds into a TFSA, a contribution in kind, may result in capital gains or losses because, under the regulations, one is deemed to have sold the investments at fair market value when they are transferred into the TFSA. While a resulting capital gain will be treated at tax time like any other capital gain, a resulting capital loss will not be deductible.

TFSAs and RRSPs side by side
While some Canadians will have enough money to both max out their RRSP contributions and put money in a TFSA, many more will not afford to do both. Each offers relative advantages, and in particular, the tax advantages offered by an RRSP or a TFSA will depend on the planholder’s income tax rate at the time of making the contributions and what it will be after retirement.

If a person expects their income tax rate to be higher when they are working than when they retire (taxed higher when making RRSP contributions than when making withdrawals in retirement), then they are better off with an RRSP.

In another scenario, a TFSA may be the better choice. An individual with a modest income and in a low tax bracket when making their RRSP contributions may find themselves in a higher tax bracket after retirement when they have to start withdrawing from an RRSP. People in that situation will be better off with a TFSA, where they will save more by not being taxed on their withdrawals than they would save on tax-deductible contributions to an RRSP.

However, the ideal case, for those who can afford it, is to have both. Understanding TFSAs states, “…the ideal solution is to have both an RRSP and a TFSA. The tax refund resulting from the RRSP contribution can be put into a TFSA, where there will be less temptation to spend it.”

TFSAs will continue to grow in popularity with investors and present a great opportunity for financial planners. As we look at 2010, successful advisors will know the rules, regulations, and advantages and disadvantages of TFSAs as well as they know the rules concerning RRSPs.

Below is a chart from Understanding TFSAs that sums up the basic differences between TFSAs and RRSPs.

Dr. Roberta Wilton is president and CEO of CSI, director of the CSI Research Foundation, vice-chair of the International Forum for Investor Education and member of the Advisor Council of the Learning Partnership in Toronto.

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