The Tax-Free Savings Account (TFSA) has been in existence for more than a decade, but for many Canadians it remains an underutilized wealth accumulation tool.
In a TFSA, you have the flexibility to invest in similar securities as you would in your Registered Retirement Savings Plan (RRSP) or non-registered investment account.
Canadians can grow their investments and savings much faster because income and growth from a TFSA are completely tax-free (since contributions are made using after-tax dollars).
Furthermore, amounts withdrawn from a TFSA will be added back as available contribution room starting the year following the withdrawal.
For example –
A $2,000 withdrawal this year can be replaced next year without affecting next year’s $6,000 contribution room. Therefore, you can contribute $8,000 next year without causing an over-contribution (assuming no unused room). For seniors, withdrawals from a TFSA will not affect eligibility for federal income-tested benefits such as Old Age Security (OAS).
Saving for retirement: RRSP or TFSA?
Deciding between an RRSP and TFSA will depend on your savings needs, as well as your current and future financial situation.
Generally, if you expect to be in a lower tax bracket during retirement, then RRSP contributions provide a benefit in deferring tax until those years. Any withdrawals from RRIFs and annuities are considered taxable income since they were funded with pre-tax dollars.
If you expect to be in a higher tax bracket in retirement, TFSA contributions may be more attractive given that all withdrawals will be tax-free.
An RRSP must be converted to a Registered Retirement Income Fund (RRIF) or an annuity, or withdrawn by the end of the year you turn age 71.
TFSAs have no such requirement, and can continue to accept contributions indefinitely to shelter income. TFSAs can benefit pensioners looking to manage their tax burden, especially if they are earning taxable income from part-time or consulting work.
TFSA contribution limits are the same for everyone, regardless of how much you earn or contribute to your pension. If you are already contributing to your RRSP, it might be a good option to put the refund generated into your TFSA.
Ultimately, there may be no need to choose one over the other.
A TFSA can effectively complement your RRSP as a strategy for retirement savings, as well as for other objectives described below. Using TFSAs and RRSPs together can bring you closer to your goals as part of your overall financial plan.
TFSAs are not just for retirement
Short- and medium-term goals
TFSAs are useful in providing for an emergency, major purchase or vacation, since there are no restrictions on withdrawing the funds** and the withdrawals are tax-free. By contrast, withholding tax will apply on RRSP withdrawals. Therefore, to cover the tax liability, you must withdraw more from your RRSP than you actually need, or make up the shortfall with other funds. In most cases, TFSAs offer the flexibility and tax efficiency to accommodate short-term income needs.
Taking Advantage of TFSAs
Income-splitting opportunity
TFSAs represent an effective way to split income among family members, such as your spouse and adult children. You may provide a gift to help them make a contribution to their TFSA. They are responsible for their own account and contribution room. Income tax attribution does not apply on TFSA earnings as they are tax-free.
Education savings
Normally, a Registered Education Savings Plan (RESP) is the standard vehicle to save for a child’s education. It offers Canada Education Savings Grants (CESGs) of up to $7,200 over a lifetime while contributions are made before age 18. RESP savings can grow tax deferred until a child beneficiary receives payments made from the RESP. One potential drawback is the loss of certain RESP benefits if your child does not pursue a post-secondary education. On the other hand, the use of TFSA savings allows for flexibility in this case and may be considered a desirable complement to RESPs in saving for a child’s education.
Investment transfer
You may want to consider transferring investments held in a non-registered (taxable) account to your TFSA, known as an ‘inkind’ contribution. If the investments have appreciated in value, this transfer would trigger a taxable capital gain. However, be aware that you will not be allowed to claim a capital loss for tax purposes if your investments have depreciated in value. Consult with your tax advisor for more information.
Estate planning
TFSAs can help minimize taxes upon your death and maximize the value of your estate, which is especially important for highnet-worth individuals. If you name your spouse as successor
holder, he or she will inherit and maintain the account’s tax-free status without affecting his or her own contribution room. Naming children as beneficiaries allows them to inherit the account directly, avoiding probate fees. Note the tax-free status is lost on death when the account passes to a beneficiary. Your children could use inherited TFSA funds to contribute to their own TFSA as a tax-free method of inter-generational wealth transfer.
The following table summarizes several features of a TFSA:
TFSAs can be attractive investment and savings vehicles for Canadians 18 years or older.
Take the time now to consider using a TFSA as part of your overall savings and investment strategy. Contact your Scotia Wealth Management relationship manager today to explore these opportunities.
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