Profit from Tax-Free Savings Accounts

Starting in 2009, Ottawa’s new Tax-Free Savings Accounts (or TFSAs) will let you earn investment income — including interest, dividends and capital gains — tax free. The new accounts are open to Canadian residents who are at least 18 years old and have filed at least one tax return.

A nice complement to RRSPs

Unlike RRSP contributions, TFSA contributions DON’T give you a tax deduction. But you pay NO tax on TFSA withdrawals. You’ll have a maximum you can contribute each year, regardless of income.
It will consist of the sum of these three amounts:

1) $5,000 a year (after 2009, this annual amount will be indexed to inflation and rounded to the nearest $500 on a yearly basis), plus

2) Any previous TFSA withdrawals not yet added back, plus

3) Any unused contribution room from previous years.

You’ll add these three sums to compute your TFSA contribution limit for the current year.

You may have multiple tax-free savings accounts. However, the combined yearly contributions to your accounts must be within your annual contribution limit.

Choose a TFSA when income is low

Both tax-free savings accounts and RRSPs let you accumulate investment income, tax free. But TFSA withdrawals, from contributions or investment income, are not taxable. Nor are TFSA contributions tax-deductible.

In contrast, Ottawa taxes RRSP (and RRIF) withdrawals just like ordinary income, without the tax breaks you get on capital gains or dividends from taxable Canadian companies. This will make tax-free savings accounts an important part of retirement planning.

If funds are limited, you may need to choose between RRSP and TSFA contributions. RRSPs may be the better choice in years of high income, since RRSP contributions are deductible from your taxable income. In years of low or no income — such as when you’re in school, beginning your career or between jobs — TFSAs may be the better choice.

Investing in a TFSA in low income years will provide a real benefit in retirement. When you’re retired, you can draw down your TFSA first, then begin making taxable RRSP withdrawals.

The TFSA will also provide seniors with a tax-free savings vehicle to meet ongoing savings needs, even when they are no longer qualified to make RRSP contributions, either because of age or because they have no taxable income.

RRSP-like investment choices

TFSAs can generally hold the same investments as an RRSP. This includes cash, mutual funds, publicly traded stocks, GICs and bonds.

However, because both gains and withdrawals in a TFSA are not taxable, you’re best to hold investments in your TFSA that earn high current income.

This includes savings accounts, as well as interest bearing investments such as GICs and dividend paying stocks. Foreign stocks, including U.S. stocks, are ideal for a TFSA, because U.S. dividends are not eligible for the Canadian dividend tax credit and are taxed like interest.

Capital losses in TFSAs can’t be claimed, so avoid holding risky aggressive stocks in your TFSA.

Use TFSAs for income splitting

Regardless of whether you have made your own full or partial contribution to your TFSA, you can give funds to your spouse to use as a TFSA contribution, within the spouse’s TFSA contribution limit. (Note that the contribution becomes the spouse’s property.) Joint TFSAs are not allowed.

Your spouse can withdraw funds from their TFSA at any time, tax free, and with no attribution of income back to you. Inheriting TFSA assets on the death of your spouse has no effect on your TFSA contribution limit.