The Proposed Tax-Free Savings Account

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1 The Proposed Tax-Free Savings Account The Conservatives 2006 election promises included a proposal to eliminate capital gains taxes where the proceeds were reinvested within six months. Taxpayers and financial advisors had been monitoring developments in this area and awaiting the introduction of this measure. Some may suggest that this measure is now off the table with the introduction of the Tax-Free Savings Account (TFSA) proposal that was contained in the 2008 Federal Budget. The Budget documents in fact refer to this plan as A Savings Plan for All Canadians. Whereas changes to the capital gains mechanism might have mainly benefited the affluent, this arrangement provides broad-based tax relief. The proposed Tax Free Savings Account (TFSA) is a new registered plan allowing Canadians over age 18 to realize tax savings on their investment earnings. As stated by the Department of Finance (Finance), As the TFSA matures over the next 20 years, it is estimated that, in combination with existing registered plans, it will permit over 90 per cent of Canadians to hold all their financial assets in tax-efficient savings vehicles 1 Finance views the TFSA as a new general-purpose savings account slated for introduction in The TFSA has many attractive features. However, as detailed legislation is not yet available, the final form is not yet known. I. Proposed Features (a) Eligibility Starting with the 2009 taxation year, individuals age 18 and older may open a TFSA (or more than one TFSA). They will have to provide a Social Insurance Number to the plan issuer when the account is opened. 2 (b) Contribution Limits Contribution room of $5,000 will be created each year. 3 The $5,000 will be indexed to CPI, rounded to the nearest $500. With a 2% rate of inflation, the $5,000 will increase to $5,500 in 2012, $6,000 in 2017, and so forth. 4 If we assume that inflation remains at 2% throughout the 20-year period ending with 2028, TFSA contribution room will reach $121,000. This is a substantial amount for most Canadians. The following table shows the cumulative balances after a 10 and 20-year period. It is clear that once this system matures, the balances in these plans could be substantial. 1 See Chapter 3 of the 2008 Federal Budget of February 26, See Budget 2008 Budget Plan Annex 4: Tax Measures: Supplementary Information 3 See 2, above. 4 See Budget 2008 Budget Plan Chapter 3: Strengthening Canada s Tax Advantage PC 6303A

2 TFSA Balances Year Total Contributions Including 4% Including 6% Including 8% 2018 $ 54,500 $ 67,600 $ 75,399 $ 84, $ 121,000 $ 182,502 $ 226,952 $ 284,304 Assumes: 1. Contribution made on January 1st 2. Contribution room indexed to CPI of 2%, rounded to nearest $ Interest accrued on Dec. 31st The contribution room is carried forward indefinitely. 5 Let s assume that John (age 54) was not able to contribute to the arrangement until 2011, the year in which he received a small bequest. He could make a contribution of $15,000 in that year. The contribution room is also replenished. Let s assume that in 2013 John withdrew $20,000 (including investment earnings) from the arrangement. Finance has stated any amounts withdrawn from an individual s TFSA in a year will be added to the contribution room for the following year. 6 John will be able to recontribute the $20,000 to the plan when he has the available funds, and will continue to be able to earn tax-free investment income on the amount. Of course, if he does not have existing TFSA contribution room, he will have to make the contribution in the next year. Without the existing TFSA contribution room, amounts cannot be recontributed in the same taxation year. Excess contributions will attract a 1% per month penalty. 7 (c) Treatment of TFSA Income for Tax Purposes Contributions made to a TFSA are not deductible for tax purposes. However, income (including capital gains) earned in the plan is not taxable, nor are amounts withdrawn from the TFSA. 8 Amounts withdrawn from the TFSA are also not included in income for purposes of determining eligibility for certain income-tested benefits or credits, including: Canada Child Tax Benefit, Goods and Services Tax Credit, Age Credit, Old Age Security Benefits, Guaranteed Income Supplement Employment Insurance Benefits

3 (d) Qualified Investments The TFSA will generally be able to hold the same investments as Registered Retirement Savings Plans (RRSPs). However, a TFSA will be prohibited from holding investments in any entities with which the plan holder does not deal at arm s length. For these purposes, entities in which the plan holder is a specified shareholder will be included. (The specified shareholder definition looks at whether the account holder and non-arm s length persons hold an interest of 10% or greater.) 10 TFSAs will thus be able to hold a wide range in investments, including mutual funds, segregated funds, etc. (e) Non-Deductibility of Financing Costs Because income and capital gains of the TFSA are non-taxable, as are withdrawals, interest charges incurred to make contributions to the TFSA are not deductible for tax purposes. 11 (f) Collateralization The tax rules will not prohibit a taxpayer from using TFSA assets as collateral. 12 (g) Attribution Rules A spouse or common-law partner may open a TFSA to which their partner contributes. The tax rules will specifically provide that income attribution does not apply. 13 (h) Tax Treatment at Death The TFSA will lose its tax-exempt status at death. Income and capital gains accrued after the individual s death will be taxable. 14 However, where the taxpayer has a spouse or common-law partner at the time of death, tax-exempt status will be retained where one of two situations arise. First, the spouse or commonlaw partner may be designated the successor account holder. Second, the assets of the deceased s TFSA may be rolled over on a tax-free basis to the surviving spouse s or common-law partner s plan. This transfer does not have any impact on the survivor s contribution room. 15 (i) Breakdown of Marriage or Common-Law Partnership Where there is a breakdown of a marriage or common-law partnership, plan-to-plan transfers will be permitted. There is no impact on either spouse s or common-law partner s contribution room. 16 (j) Non-Residents When an individual leaves Canada, he or she will be able to maintain their TFSA. The income earned by the plan will continue to be exempt for Canadian tax purposes. However, no contributions may be made while the individual is non-resident, nor will the contribution room accrue for a year throughout which the

4 person is non-resident. 17 Of course, the individual will want to seek professional tax advice as to how the tax rules for the country-of-residence will treat the TFSA. (k) Issuers Financial institutions currently offering RRSPs will be permitted to offer TFSAs. (l) Tax Reporting Canadian taxpayers are familiar with the RRSP room calculations that appear on Notices of Assessment that the Canada Revenue Agency (CRA) issues to them. CRA will now also calculate the TFSA contribution room for anyone 18 or over filing a tax return. While those who don t file will be able to establish their contribution room at a later date, it is recommended that this be done on a timely basis to ensure entitlements to credits (e.g., GST) are not lost. TFSA issuers will have to file annual information returns, so that CRA will be able to calculate the TFSA contribution room, and to otherwise monitor compliance. 18 II. Comparing the TFSA to the RRSP and Non-Registered Savings The tax rules for RRSPs provide that contributions are deductible for tax purposes. The investment earnings of the plan are tax-deferred, with the amounts (i.e., both contributions and investment earnings) only being taxable when withdrawn from the plan. A taxpayer will be able to deduct the contributions (up to ITA-limits) in the year that they are made, or may choose to deduct the contributions in a later year. The taxpayer will realize tax savings when he or she deducts the contribution. The value of the savings is determined by the taxpayer s marginal tax rate at that time. Conversely, the amounts withdrawn from the arrangement are taxed, with the taxes payable at that time being calculated using the marginal tax rate then in effect. The following chart shows what happens when an after-tax contribution of $3,000 is made to the TFSA. This compares to a $5,000 pre-tax contribution to an RRSP. Assuming identical investment earnings of 6% over a 20-year period, the RRSP contribution of $5,000 compounds to $16,036. With a 40% assumed tax rate applying in the year of withdrawal, the net cash in pocket is $9,

5 Comparison of TFSAs, RRSPs and Non-Registered Savings TFSA RRSP Open Account Pre-tax income $ 5,000 $ 5,000 $ 5,000 Tax owing (40%) $ 2,000 $ - $ 2,000 Net contribution $ 3,000 $ 5,000 $ 3,000 Value of account after 20 years at 6% $ 9,621 $ 16,036 $ 6,086 Tax on liquidation (40%) $ - $ 6,414 $ - Net cash in pocket $ 9,621 $ 9,621 $ 6,086 Net annual after-tax rate of return 6.00% 6.00% 3.60% Notes: 1. In open account, taxes are paid annually at a 40% tax rate. The TFSA contribution is made with after-tax dollars. It also compounds at 6% to $9,621. However, no taxes apply when the amounts are withdrawn from the TFSA. Thus, the taxpayer retains the full $9,621. When there are identical rates of return in the TFSA and RRSP, and the same tax rate applies in the year of contribution and withdrawal, the two plans provide the identical cash in pocket. When we look at the same after-tax amount being invested in an open account, taxes are paid at a 40% rate each year. Thus, at the end of the same 20-year period, the net cash in pocket is diminished. (Of course, the net cash in pocket would increase, if capital gains or Canadian dividends were earned, rather than income that is taxed at full rates.) III. Comparison of Various Registered Plans Appendix 1 compares RRSPs, Registered Educational Savings Plans (RESPs) and the TFSA. It is clear that the TFSA is a flexible arrangement. The plan holder may put the funds to any desired use. In fact, funds withdrawn from the arrangement may be recontributed to the plan. It may supplement retirement savings (or indeed substitute for an RRSP). It can also supplement the educational use of the RRSP and RESP. Taxpayers and their financial planners will have to decide which plan suits the taxpayer best. The choice will not always be clear, as a lot of considerations enter into the decision making process. The appropriate solution will need to take into account the taxpayer s specific circumstances. Let s look at a few possible uses. We anticipate that younger taxpayers may like the arrangement, as it will allow them to save on a tax-effective basis for their first home. Here, the TFSA could supplement the Home Buyer s Plan (HBP) under a RRSP. (Where the taxpayer contributes to an RRSP, tax savings will be realized. Up to $20,000 could then be withdrawn from the RRSP under the HBP. Thus, pre-tax dollars are used for the HBP.) 5

6 Some taxpayers will have exhausted their RRSP limits. Thus, they will be able to contribute tax-paid amounts to this arrangement. If the TFSA limits are sufficient to cover their investments, they will in fact be in a position of leaving their TFSA balance to their heirs on a tax-paid basis! Hence, there will be no tax liability at death because of a deemed disposition of these assets. The heirs, if younger, and if they have sufficient TFSA contribution room, may choose to contribute the bequest to their TFSA. IV. Summary The TFSA is a welcome addition to registered plans. It is a plan that will appeal to Canadian taxpayers because of both its flexibility and tax-effectiveness. We eagerly await the release of the draft legislation and will prepare a detailed analysis at that time. This document is intended for general information only. It should not be construed as legal, accounting, tax or specific investment advice. Clients should consult a professional advisor concerning their situations and any specific investment matters. While reasonable steps have been taken to ensure that this information was accurate as of the date hereof, and its affiliates make no representation or warranty as to the accuracy of this information and assume no responsibility for reliance upon it. 6

7 Appendix 1 Brief Description of Various Registered Arrangements Purpose of Arrangement RRSP RESP TFSA Education Primary purpose of arrangement is retirement. However, withdrawals of $20,000 per course of study are permitted under the Lifelong Learning Plan. Amounts are included in income if not repaid. Primary purpose of arrangement is education. Assistance is available via the Canada Education Savings Grant (CESG) program. Home Ownership While primary purpose of arrangement is retirement, withdrawals of $20,000 are permitted under the Home Buyer s Plan. Other uses preretirement While primary purpose of arrangement is retirement, withdrawals are permitted at any time. Retirement Primary purpose of arrangement. Not intended Not intended Not intended. Amounts withdrawn from the plan may be put to any use. Taxation of arrangement Contributions up to limits imposed in the Income Tax Act (ITA) are tax-deductible. Contribution room is not replenished, as amounts withdrawn from the plan except for limited purposes (e.g., LLP and HBP) may not be recontributed. Investment earnings in plan are tax-deferred, and only taxed at time of withdrawal. Amounts withdrawn from the arrangement are included in net income, thus affecting various income-tested benefits and credits. Accumulated savings must be drawn down at age 71 Contributions up to limits imposed in the ITA may be made to the arrangement, but are not deductible for tax purposes. Investment earnings in the plan are taxdeferred. Amounts withdrawn from the plan (investment earnings and CESG) are taxable. ITA contains limits as to when plan must mature (current 21- year contribution period and 25-year anniversary being extended by 10 years, per proposals made in the 2008 Federal Budget) Contributions up to limits imposed in the ITA may be made to the arrangement, but are not deductible for tax purposes. Contribution room is replenished as amounts withdrawn from arrangement may be recontributed Investment earnings in the plan not taxed on either an annual basis or when withdrawn Amounts withdrawn from the arrangement are not included in net income, thus not affecting various income-tested benefits and credits No age limits as to when plan must mature. 7