‘Tis the Season and the Government is Playing Santa!

If you have been to a mall or close by one lately, you will know that the Holiday season is upon us. The sound of jingles fill the air, the malls are busy, and children are checking out the newest toy for their wish list. Well, the government is getting into the act and giving for the New Year although it’s really not a surprise!

In the 2008 budget, the government announced the Tax-Free Savings Account (known as the “TFSA”). This was a big gift to all Canadians over the age of 18 and it’s about to be delivered! Essentially, the TFSA is a registered savings account that allows you earn investment income on the contributions tax-free and the funds can be withdrawn at any time. The accounts will become effective January 1, 2009 and investors will be allowed to contribute up to $5,000 per year. The contribution amount will be indexed for future years to the rate of inflation.

But that’s not all of it! The other great feature is that your annual contribution amount is cumulative meaning that if you miss putting $5,000 into the account one year, then you can put $10,000 into the account in the following year. There is no limit on the number of years that the unused contribution room can be carried forward. Also, if you withdraw from the account in a given year, the withdrawal amount is added back to your contribution amount so you can reinvest it later!

Here’s an example:

Jane Smith opens a TFSA at her bank and puts $5,000 into the account. She invests the funds in a publicly traded stock at a market price of $5 per share. Over the year, the stock increases in value to $10 per share and she sells the stock resulting in a capital gain of $5,000. If this investment was in a regular trading account, Jane would pay tax on the gain of approximately $1,150 assuming she is in the highest personal marginal tax bracket. Since the investment was in her TFSA, Jane does not pay any tax on the gain and has the full $10,000 to either leave in the TFSA and re-invest or take out for some other use. If Jane takes the funds out, her withdrawal amount is added to her contribution amount for the following year so she can contribute $15,000 (assuming no indexing).

Within the account, you can invest in a wide variety of investments that mirror the same type of investments that you have in other registered accounts such as your RRSP. These include GIC’s, publicly traded shares, bonds, mutual funds, and certain shares of small business corporations.

The TFSA is not a replacement for your Registered Retirement Savings Plan (“RRSP”). The RRSP is designed for long-term retirement savings whereas a TFSA is designed for general savings. I would recommend that you contribute to your RRSP first before a TFSA since you get the added benefit of the tax deduction with the RRSP contribution. The TFSA is a great investment vehicle to help with the following:

Additional retirement savings above your contribution room for your RRSP.
Saving for a major purchase such as a house, vacation or a new vehicle.
General savings (short-term and long-term)

What does the tax advantage mean in the long run? Since you are not taxed on the investment income earned within the TFSA, you will have a larger principal balance to earn an investment return on over the investment period. Let’s take an example: Jane Smith invests $5,000 per year for 10 years in GIC’s earning interest at 2% per annum. If Jane invests that outside a TFSA, at the end of the 10 years she would have $53,070 saved including her after-tax return on the investment. If she did the same investment inside a TFSA, she would have $55,850 or $2,780 more since the investment income is not taxed.

Investments in a TFSA will be allowed to be used as security to cover loans if needed. Since the accounts allow for tax-free investment earning, you will not be able to deduct interest carrying costs for any borrowed money used to be invested into your TFSA unlike that currently allowed for investments.

If you currently hold investments outside of your RRSP, then you can transfer those investments to a TFSA to avoid tax on the future earnings. If you decide to transfer existing investments, you will need to consider the tax effect of doing so in order to make the proper decision. As a result, I suggest that you discuss this with your tax advisor to make an informed decision.

In closing, the TFSA is a big boost for Canadians and I highly encourage those who are looking to invest to visit their financial institution or investment advisor and open an account. Many of the institutions are allowing you to open the account now but the contribution into the account cannot occur until January 2, 2009 when the legislation becomes effective.

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