4th Annual Dollars & Sense Survey: Turning up the heat

On June 18, the federal government passed its 2008 budget bill into law, making the Tax Free Savings Account (TFSA) available to millions of Canadians beginning in January 2009. This day likely failed to resonate with the average Canadian, but I can tell you I certainly paid attention. Ever since the federal government announced the TFSAs in February, I have been considering what their impact for advisors and financial services firms might be.

It’s safe to say that these accounts will have a large effect on advisors’ businesses, bringing in bundles of money. How much? How about $130 billion?

You are probably doing the math and thinking I simply multiplied the number of Canadians over 18 by the $5,000 available contribution room — and you would be correct. You then probably thought, “Clients can only contribute $5,000 each so how am I going to drive revenues for my financial advisory business on such a small amount?” This is a common question, but it’s the wrong way to look at these accounts. You should be asking, “How much money could I lose if I don’t offer these accounts?” That calculation is easy — how many clients do you have?

In many ways, TFSAs represent one of the most important tax savings and investment vehicles Canadians have seen in some time. In this column and ones that follow, I will be examining what the impacts of TFSAs will be, as well as helping advisors understand the nuts and bolts of these accounts. I will also leverage Fidelity’s international experience with similar accounts (think Roth IRA in the U.S.) to help them understand the growth potential of TFSAs.

Although I’m sure most are already generally familiar with the account’s details, I thought I would highlight some of its key features and point out some specific opportunities for advisors that I’ll explore in future articles.

TFSAs share the characteristics of both taxable accounts and RRSPs. They’re similar to RRSPs in that investments held within the account grow tax-free, meaning that there is no tax on interest, dividends or capital gains earned on investments within a TFSA. TFSAs are subject to similar qualified investment rules as RRSPs and have a similar concept of “contribution room.”

Unlike RRSPs, investors do not receive a deduction from income tax when they make a contribution to their TFSAs and do not include any withdrawals made from TFSAs in their income. Investments are contributed to the accounts on an after-tax basis, similar to investments held in a regular taxable account; however, unlike a regular taxable account, as stated above, the income generated from TFSA-held investments will be tax free.

Furthermore, since withdrawals will not be subject to tax and will not be considered taxable income, clients’ income-tested benefits and income tax credits such as OAS, EI benefits and the age credit will not be affected by TFSA withdrawals.

Contribution room

Canadian residents, age 18 and older, will receive $5,000 of contribution room each year, regardless of their income level. In subsequent years, the annual amount of contribution room will be indexed to inflation in $500 increments. Any unused contribution room is carried forward indefinitely. Any withdrawals from a TFSA are added back to one’s contribution room for the following year. Again, for tax purposes, no differentiation is made between a return of capital and investment growth and income when a withdrawal is made. This means that your clients can withdraw a particular amount from the account and subsequently reinvest this same amount without losing any contribution room. Similar to RRSP contribution room, a TFSA’s contribution room will be tracked as part of the annual tax return filing process.

Tax savings

To see the benefits of using a TFSA, calculate the potential tax savings a typical account-holder might receive in the first year. Say that this individual invests the full $5,000 at the beginning of the year and earns 6% in the first year. He’s earned $300 of income. Now say that this is all interest income that would have been taxed at the highest rate; therefore, he will have saved about $150 in tax. The cynic in me thinks that the tax savings in the first year is rather paltry. However, the realist in me understands that this $150 tax savings represents significant future value to this individual, since this $150 will grow tax free until it is withdrawn, and quite likely exponentially at that.

Income-splitting opportunities

Since income earned within a TFSA is not taxable, contributions made into a spouse’s TFSA will not be subject to the income attribution rules. TFSAs allow both spouses to earn tax-free investment income regardless of whose money was originally invested. While it has been observed that the current $5,000 limit per account isn’t a particularly large sum in relation to its overall impact on most advisors’ businesses, I think it’s important to keep in mind that everyone 18 and older can open one. This could prove an interesting business-building opportunity for many advisors. Consider that parents of adult children might do well making contributions on their kids’ behalf to take advantage of the account’s flexibility and potential for tax-free growth. In the case of a family of four, TFSA contributions of $20,000 could result, with some of this coming in the form of incremental savings.

Retirement

The TFSA is designed to complement the RRSP. Contributions can be made to both plans each year. A TFSA can provide more flexibility in retirement since clients can choose which source of income to utilize during retirement. Furthermore, TFSAs are well suited to help “smooth” clients’ income in retirement, particularly since there are no restrictions on TFSA withdrawals, and since income-tested benefits such as OAS and GIS will not be affected as TFSA withdrawals are not included in taxable income.

Carrying charges

If a client borrows to invest in a TFSA, the interest on the loan will not be deductible for tax purposes since the investment income earned is not taxable. This is similar to the deductibility of interest on a loan to invest in an RRSP.

It is easy to see why I like the TFSA. I like that this is another vehicle to save for retirement. I like that if I want to dip into my TFSA to make a big purchase like buying a cottage (granted, clients will need to wait for these accounts to accumulate before they can buy something expensive), I can do so without penalty. I like that I can contribute to my spouse’s or adult children’s TFSAs without attribution applying. Finally, I like the flexibility to be able to manage my income stream and taxable income in my retirement years.

Canadians should embrace these accounts, and, indeed, advisors should help facilitate this embrace. The TFSA stands one day to become one of the most important vehicles for individual savings and wealth management in Canada. Of course, for this to happen, Canadians need to act. Come January 1, 2009, there will be somewhere in the region of $130 billion of unused TFSA contribution room in this country. And that’s just counting the room afforded to the accounts in their inaugural year. For Canadian advisors, this is an opportunity that’s hard to miss.