Based on the evidence so far, we might conclude the Tax Free Savings Accounts (TFSAs) have had a rather lukewarm debut. In the six months since their January 1, 2009 introduction, Canadians opened 3.6 million TFSAs with an average balance of about $3,400, according to Investor Economics.

Clients did catch on though: By the end of June, total assets in the accounts stood at $12.4 billion.

Initially, some lamented the fact that individual TFSA contributions were limited to a measly $5,000 a year. And they were launched just as Canadians started feeling the first pinch of the worst recession since the Second World War ended. Early this year, many investors were far more comfortable on the sidelines regardless of any potential opportunities they might have missed in the area of tax-efficient investments.

But under the circumstances, the initial account and balance totals aren’t insignificant, even when compared to Registered Retirement Savings Plans (RRSPs). Statistics Canada reports the average RRSP contribution in 2007, the most recent full year available and a relatively good year for the markets, was $5,412; and the median contribution was just $2,780. Certainly there are a lot more RRSP contributors – 6.3 million in 2007 – but those plans have been around for more than 50 years.

Vast potential

Rather than dwell on the early returns (and they’re not off to a bad start), client-facing advisors should concentrate on the potential TFSAs represent as one of the most important savings vehicles available to Canadian investors. Consider the following possibilities:

  • We don’t know what final totals we’ll get for the first full year of TFSA usage and contributions, but initial results suggest these accounts are going to become extremely popular. There’s growing awareness that TFSAs provide a great deal of flexibility to achieve various savings goals, so much so that they may one day rival RRSPs for popularity.
  • The $5,000 in initial contribution room may seem small, but it’s renewed annually. On January 1st, 2010, 26 million Canadians aged 18 or more will receive an additional $5,000 in tax-free contribution room from the federal government. And that happens every year, for life. The same amount will keep getting added annually, and it’s not hard to imagine New Year’s Day becoming “TFSA day” for millions of Canadian investors – a time to start sheltering more of their savings from taxation, permanently.A multifaceted investment

    There’s always a wonderful story to tell clients about the versatility of TFSAs as savings tools, since they have benefits on their own as well as in combination with other investment vehicles.

    In fact, I can’t think of a client scenario that wouldn’t benefit from a TFSA in the context of a larger financial plan. There are a number of ways to highlight how TFSAs can work in tandem with clients’ other investments to help them achieve various savings goals.

    Everyday savings

    Most obvious are near-term objectives such as buying a new car, taking a vacation or setting aside cash for extraordinary household needs – the kinds of purchases people make when they have a degree of confidence in their economic prospects.

    Provided your clients can take advantage of the available contribution room, TFSAs should be the primary savings vehicles to meet these needs because they allow tax-free growth and withdrawals. This makes them clearly preferable to non-registered accounts, which clients would only contribute to for savings purposes once they have used up their TFSA contribution room.

    Remember, because of the administrative requirements and applicable withholding taxes, RRSPs don’t offer the tax savings flexibility of TFSAs, and they’re not particularly well suited for more general savings goals.

    Buying a home

    Low interest rates are enticing both new and experienced home and recreational property buyers back to the market.

    A TFSA is a great place to park funds for a tactical purchase, or as a complement to an RRSP Home Buyers Plan. The HBP provides benefits similar to a TFSA because it allows investors to borrow from RRSPs for an initial home purchase. However, HBPs are more restrictive than TFSAs because they limit borrowings to $25,000. Also, any amount borrowed from an RRSP must be repaid within 15 years.

    Over time, the TFSA’s tax-free growth, straightforward tax-free withdrawal characteristics, and annual growth in contribution room will make it a far more significant savings vehicle for anyone considering this kind of purchase. Of course, until the contribution room available in TFSAs grows to more substantial proportions, most home and recreational purchases will still be funded by non-registered accounts.

    Saving for an education

    Say your clients want to save for the education of a child under age 18. Generally the best method is to open an RESP and take advantage of the federal government’s Canadian Educational Savings Grant (CESG).

    But once they’ve received the maximum CESG grant, clients can then invest in their own TFSAs to gain from the tax benefits. Then they can reinvest in their child’s RESP the following year in order to maximize the grant received.

    Now that many of your clients’ adult children are back in school, you can point out another virtue of TFSAs in education planning. Once a child turns 18, eligibility for the CESG ends, but clients could open additional TFSAs in the child’s name for educational savings (and income splitting opportunities) because of their easy access and tax advantages.

    For clients planning to finance training or education for themselves or a partner, Ottawa’s Lifelong Learning Plan (LLP) provides benefits similar to the HBP. Funds can be borrowed from RRSPs for LLPs on a tax and interest-free basis so long as they are repaid within 10 years. Of course, TFSAs offer a natural compliment to this strategy as well.

    Saving for retirement

    When it comes to saving for retirement, clients don’t have to choose between an RRSP and a TFSA. Advisors must explain they can have both.

    TFSAs are designed to mirror RRSPs and provide your clients with the same potential to save on taxes during their lifetimes. But help the clients understand the benefits and drawbacks of both these plans and to know when to use each to the greatest effect. As an advisor, you know it also helps to have a sound grasp of the client’s anticipated retirement income.

    Broadly, the decision to invest in either a TFSA or an RRSP depends on an investor’s tax level at the time of contribution and the time of withdrawal. If the investor’s marginal tax rate is higher at the time of contribution than it’s likely to be when withdrawals are made in retirement, it makes more sense to invest in an RRSP since it will defer tax payments to a future time when income, and consequently the client’s marginal tax rate, will be lower. If the situation were reversed and income is likely to be higher later in life, then investing in a TFSA makes more sense since eventual withdrawals will be tax-free. If income is likely to remain fairly consistent before and after retirement, then investing in both types of plans can be equally beneficial.

    Right plan at the right time

    One or the other of these plans can take precedence at different times in a client’s working life and at retirement:

  • Early in a client’s career when income and, consequently, the marginal tax rate, are likely lower, it makes more sense to invest in a TFSA;
  • At mid-career, when income is likely to be higher, the client’s marginal tax rate may be essentially the same as it will be in retirement. At this stage, it can work equally well to invest in either type of plan since additional dollars will be taxed at the same rate. Of course, if there are other financial issues at this stage such as a potential need for liquidity, investing in a TFSA that permits tax-free withdrawals at any time will make more sense;
  • Later in their careers, your clients’ earnings will likely peak and be higher than anticipated retirement income. Given the high marginal rates prevalent at this stage, it’s advisable to invest in an RRSP and defer taxes. If contribution room has been used up, any excess savings can be invested in a TFSA.Once in retirement, your clients will normally want to put additional savings into TFSAs, provided they have contribution room. As TFSA withdrawals are tax free, tested benefits such as Old Age Security and the Guaranteed Income Supplement are not affected. But if clients continue to have high income in the early years of retirement and are 71 or younger – or have spouses in that age bracket – then RRSPs may be preferable so long as there’s contribution room. After 71, of course, RRSP savings are rolled into RRIFs and minimum withdrawals are mandatory. If your clients don’t need these funds for living expenses, they can invest them in TFSAs.

    Turning awareness into knowledge

    Numerous surveys have found general awareness about TFSAs is already quite high. But there’s a difference between awareness and a working knowledge that translates into informed decisions.

    That’s where advisors can have a strong and beneficial impact on their clients. Take the earliest opportunity to educate clients about ways TFSAs can form an essential part of a holistic financial plan and prepare them for the future.

    And remind them that January 1st, in addition to marking the first day of a new year, is also when they get that renewed $5,000 gift in permanent tax-free contribution room. Over many years, those gifts mount up.

    Three good reasons to recommend TFSAs

    Even though TFSAs present a longer-term proposition, there are three good reasons to encourage clients to take advantage of this new tax savings room:

  • Improving economic and market conditions appear to be re-instilling some degree of confidence in investors.
  • There’s considerable competition out there to develop this business, particularly from deposit-taking institutions that see TFSAs as another strong addition to their arsenals. The same applies to you.
  • The sooner you can convince your clients to open TFSAs, the more time they’ll have to grow their investments sheltered from tax, thereby maximizing tax-free returns.TFSA or RRSP?

    Not everyone falls into these straightforward categories, but the basic rules will hold true:

  • early in a career, when earnings and marginal tax rates are low, invest in TFSAs;
  • as earnings and tax rates peak, invest in RRSPs; and
  • as retirement begins, TFSAs are preferable unless income is likely to remain very high for a few years.There’s also a compromise fallback position. When your clients are younger, it’s hard to estimate retirement income, so contributing to both TFSAs and RRSPs can provide a hedge against future eventualities