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THE TAX-FREE SAVINGS ACCOUNT

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1

THE T AX- F REE S AVINGS A CCOUNT

BY READING THIS DOCUMENT, YOU WILL:

Know the different features of the TFSA

Master the differences between a contribution to an RRSP or a TFSA

Identify target clienteles .

Last update: June 2012

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2

TABLE OF CONTENTS

1 Features of the TFSA ... 4

1.1 Account Holder ... 4

1.2 Contribution Room ... 4

1.3 Contribution Deduction and Tax on Withdrawals ... 5

1.4 Eligibility for Income-Based Benefits ... 6

1.5 Excess Contributions ... 6

1.6 Eligible Investments ... 6

1.7 Collateral Assignment and Leverage Effect ... 7

1.8 End of Marriage ... 7

1.9 Death ... 7

1.10 Termination of Canadian Residence ... 8

2 RRSP and/or TFSA ... 8

2.1 Similarities Between an RRSP and a TFSA ... 8

2.2 Differences Between an RRSP and a TFSA ... 8

2.2.1 Age for Eligibility ... 9

2.2.2 Age Limit to Contribute ... 10

2.2.3 Contribution Room ... 10

2.2.4 Contribution Deduction ... 11

2.2.5 Taxation on Withdrawal ... 11

2.2.5.1 Tax rate on contributions equals the tax rate on withdrawals ... 12

2.2.5.2 Higher tax rate on contributions than the tax rate on withdrawals ... 13

2.2.5.3 Lower tax rate on contributions than the tax rate on withdrawals ... 14

2.2.6 Withdrawals and Contribution Room... 15

2.2.7 Eligibility for Different Government Programs ... 16

2.2.8 Collateral Assignment ... 16

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3 Target Clienteles ... 16

3.1 Affluent Clients ... 17

3.2 Retirees ... 17

3.3 Clientele in the Retirement Income Planning Phase ... 17

3.4 Young People ... 18

4 Conclusion ... 18

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4 The purpose of this document is to describe the features and rules of the TFSA and to compare the TFSA and the RRSP, namely the situations in which either of these investment vehicles is most advantageous for individuals.

1 Features of the TFSA

1.1 Account Holder

Any individual who is a resident of Canada and is 18 years of age or older can establish and contribute to a TFSA.

The TFSA is a practical income-splitting tool since it will be possible to transfer money to a spouse (spouse or common-law spouse) in order for it to contribute to its TFSA

An interesting point about the previous item is that the attribution rules don't apply to TFSAs.

These rules stipulate that the donor, and not the beneficiary, must pay taxes on the income from money given to a spouse or minor child. Since the attribution rules don't apply, the richer spouse could provide the other spouse with the cash needed to make annual TFSA

contributions. This would make it easier for families who want to contribute $10,000 per year divided equally between the spouses' respective accounts.

1.2 Contribution Room

The contribution room is the same for all eligible individuals. It is not related to earned income, as with RRSPs.

Each year, contributions can reach the TFSA limit for the current year, which will be composed of three amounts:

• Each year starting in 2009: $5,000 (this annual amount will be indexed to inflation and rounded to the nearest $500);

 For example: In 2010, if a 2% inflation rate is used to calculate the new annual limit, the 2010 maximum will remain at $5,000 ($5,000 x 2% = $5,100, rounded to the nearest $500 = $5,000).

 In 2011, the new limit will be calculated as follows: $5,100 x inflation rate, and will be rounded to the nearest $500.

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• Any amount withdrawn in the previous year will be added to the current year’s contribution room;

 For example: An individual who holds a $5,000 TFSA must withdraw the entire amount. The contribution room for this person for the next year will be $10,000, namely the $5,000 annual contribution plus the amount withdrawn the previous year.

• The previous year's unused contribution room will be added to the current year's room;

 For example: An individual contributes $3,000 to a TFSA in 2009. For 2010, this person's limit will be $7,000, namely the

$5,000 annual limit and the previous year's $2,000 unused room.

1.3 Contribution Deductions and Tax on Withdrawals

Contributions to a TFSA are not tax deductible, nor is the investment income earned in the account taxable, even upon withdrawal. The main attraction of the TFSA is the fact that it is devoid of any income tax.

There are no restrictions on tax-free withdrawals from a TFSA, either in terms of the number of annual withdrawals or the amount that can be withdrawn. Even if the individual uses the TFSA to finance annual vacations, the withdrawals are not taxable and the amounts withdrawn can be replaced with new contributions in a subsequent year.

Comparisons between the TFSA and the RRSP will be discussed in a subsequent section of this document. Right now, let's compare the advantage of holding savings within a TFSA rather than a traditional non-registered savings contract:

TFSA Non-registered contract

Contribution $5,000 $5,000

Investment income (assumption: 5%) $250 $250*

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6 Tax payable (assumption: average rate of

28%)

$0 ($70)

Net value $5,250 $5,180

Annual rate of return after taxes 5% 3.6%

*The calculations are based on a weighted average tax rate of 28%, which is a diversified portfolio whose income is made up of 30% dividends, 30% capital gains and 40% interest (Source: Department of Finance Canada).

To obtain a 5% net return in non-registered savings requires a 7% gross return. This makes the TFSA ideal for non-registered savings. All individuals should first and foremost channel their non-registered savings to the TFSA account as much as possible.

1.4 Eligibility for Income-Based Benefits

Another practical aspect of the TFSA is that neither withdrawals from nor contributions to it will be taken into account for purposes of determining eligibility for income-based benefits or credits granted under the income tax structure. For example:

 Canada Child Tax Benefit

 Goods and services tax credit (GST)

 Seniors credit

 Old Age Security

 Guaranteed Income Supplement

1.5 Excess Contributions

Excess contributions are subject to the same penalty as that for an RRSP, namely 1% per month starting with the first dollar of excess contributions. But be careful, realized gains and

investment income are not included in the annual limit. The annual limit is the eligible amount of contributions only.

1.6 Eligible Investments

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7 The same type of investments eligible for an RRSP will be eligible for the TFSA, which opens the door to a wide range of investment possibilities. Based on Industrial Alliance's offer, eligible investments will include the daily interest fund, guaranteed interest funds and segregated funds, through our IAG Savings and Retirement Plan. The High interest TFSA is also available.

1.7 Collateral Assignment and Leverage Effect

Given that the TFSA is a non-registered savings vehicle, the contract can be assigned to guarantee a loan.

However, because the TFSA is a tax shelter, the interest paid on the loan made for TFSA contributions is not tax deductible.

1.8 End of Marriage

The TFSA is not included in the divisible assets of the family patrimony in the event of divorce.

However, if the marriage is under the Partnership of Acquests regime, the TFSA is part of the household assets and is subject to division.

If an amount held in a TFSA must be split between spouses, a transfer can be made with no tax consequences. This transfer doesn't affect the contribution room for either spouse. In other words, there is no reduction in the contribution limit for the spouse who receives funds from a TFSA and there is no increase in the contribution limit for the spouse who transfers funds.

1.9 Death

In the event of death, assets held in a TFSA can be rolled over to the spouse with no tax consequences.

If there is no spouse, the amounts accumulated in the TFSA remain tax-exempt. However, the income generated starting on the date of death will have to be included in the estate's tax return. If this happens, it is preferable to liquidate the TFSA before distributing the amounts to the designated beneficiary who, based on their own contribution limit, can contribute to their own TFSA and benefit from a tax exemption.

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8 1.10 Termination of Canadian Residence

Termination of Canadian residence does not result in the disposition of a TFSA. All tax benefits are maintained. The only impact on the TFSA is that the individual does not accumulate contribution room while he is a non-resident.

2 RRSP and/or TFSA

Even though the goal of the TFSA is to increase individual savings, your analysis with the client must focus on evaluating the optimal situation between contributing to an RRSP or a TFSA.

2.1 Similarities between an RRSP and a TFSA

First, the similarities between the RRSP and the TFSA:

 No annual taxation of the income generated in the contract

 Unused contributions accumulate

 Excess contributions are subject to a 1% penalty per month (one difference: the TFSA doesn’t have the $2,000 extra buffer margin that the RRSP has)

 Eligible investments

 The interest paid on the amounts borrowed to contribute to the RRSP or TFSA are not tax deductible

2.2 Differences Between an RRSP and a TFSA

These are differences between the RRSP and the TFSA which could make it necessary for an analysis of your client situation. These differences will be detailed in the coming sections, but here is a summary of the differences:

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RRSP TFSA

Eligibility age None Age 18

Age limit for contributions Age 71 None Contribution limit 18% of earned income, less

the pension adjustment (up to the annual maximum)

$5,000 (regardless of earned income)

Deduction of the

contribution 100% None

Taxation on withdrawal In the form of income None Withdrawals and

contribution room Withdrawals do not increase

contribution room Withdrawals increase the contribution room Eligibility for different

government programs Withdrawals are added to income and can modify eligibility

Withdrawals are not added to income and cannot modify eligibility

Collateral assignment Cannot be assigned Can be assigned as collateral

2.2.1 Age for Eligibility

To contribute to an RRSP requires an earned income, regardless of the age at which this income is generated. For a TFSA, you must be a Canadian resident at least 18 years of age.

This age criteria may be important for parents (or grandparents) who want to offer a TFSA to their children (or grandchildren). They will have to wait until the persons concerned reach legal age to open this type of account.

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2.2.2 Age Limit to Contribute

Well-known fact: you cannot contribute to an RRSP beyond your 71st birthday. This rule doesn't apply to the TFSA. Excellent news for clients who still have the ability to save beyond that birthday.

Clients have access to an additional tax shelter. Rather than contribute to a non-registered contract, which will generate taxable annual income (investment income), they can continue to save in a TFSA, which is tax-exempt.

The RRSP must be converted into a RRIF at that same age (71) and an annual minimum

withdrawal must be made. This does not apply to the TFSA, which has no maturity date and no minimum withdrawals (withdrawals are made according to the individual's needs).

2.2.3 Contribution Room

Annual RRSP contributions are determined according to the earned income and a pension adjustment (if applicable). A maximum limit is also determined. Therefore, annual RRSP contributions can vary from one individual to another.

The federal government has set the annual contribution limit for the TFSA at $5,000. This amount is not related to earned income or a pension adjustment. It remains the same for all eligible individuals.

For individuals who make their maximum RRSP contribution, the TFSA is an additional possibility for making tax-sheltered savings.

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2.2.4 Contribution Deduction

The advantage of the RRSP is that income taxes on the amount of the contribution can be eliminated. The TFSA remains non-registered savings and the contributions are not tax- deductible. For example:

TFSA RRSP

Income before taxes $1,000 $1,000

Income tax (assumption: 40%) $400 $0

Net contribution $600 $1,000

Investment income

(assumption: 20 years at 5.5%) $1,151 $1,918

Gross proceeds $1,751 $2,918

At first glance, the RRSP appears to be the better choice. However, this is just the accumulation phase. Planning the withdrawal of the funds is the essential step in deciding on an RRSP or a TFSA.

2.2.5 Taxation on Withdrawal

It is imperative to know your clients' current tax rate and evaluate their tax rate at retirement to properly advise them between choosing an RRSP or a TFSA contribution. Following is an

overview of the possible situations according to tax rates during active life compared to retirement:

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12 Let's look at each situation using the example shown in section 2.2.4:

2.2.5.1 Tax rate on contributions equals the tax rate on withdrawals

Tax rate on

contribution

=

Tax rate on

withdrawal

Indifference between

RRSP or TFSA

Tax rate on

contribution

>

Tax rate on

withdrawal

Advantage

RRSP

Tax rate on

contribution

<

Tax rate on

withdrawal

Advantage

TFSA

Tax rate on

contribution

=

Tax rate on

withdrawal

Indifference between

RRSP or TFSA

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13

TFSA RRSP

Income before taxes $1,000 $1,000

Income tax (assumption: 40%) $400 $0

Net contribution $600 $1,000

Investment income

(assumption: 20 years at 5.5%)

$1,151 $1,918

Gross proceeds $1,751 $2,918

Income tax on withdrawal (assumption: 40%)

$0 $1,167

Net proceeds $1,751 $1,751

When the tax rate remains the same at retirement as during active life, the net proceeds of a contribution to the TFSA or RRSP is equivalent. You will probably run into this equivalent tax rate situation with clients who contribute to a defined contribution pension plan combined with other types of savings (RRSP or non-registered).

Therefore, your evaluation should not focus on the net proceeds, but rather on accessibility to the amounts, with the TFSA being easier to access than the RRSP. A withdrawal from the TFSA during active life will not be taxable, but a withdrawal from an RRSP will be, and could increase the individual's tax rate. Does your client have the discipline to keep the amounts paid into the TFSA for retirement? Should you protect your client from himself and favour RRSP

contributions?

2.2.5.2 Higher tax rate on contributions than the tax rate on withdrawals

Tax rate on

contribution

>

Tax rate on

withdrawal

Advantage

RRSP

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14

TFSA RRSP

Income before taxes $1,000 $1,000

Income tax (assumption: 40%) $400 $0

Net contribution $600 $1,000

Investment income

(assumption: 20 years at 5.5%)

$1,151 $1,918

Gross proceeds $1,751 $2,918

Income tax on withdrawal (assumption: 30%)

$0 $875

Net proceeds $1,751 $2,043

This situation probably covers a majority of your clients. Most people plan for a retirement income equal to about 75% of their current income. This reduction in income will probably lead to a lower tax rate.

In this situation, the RRSP has an advantage over the TFSA. However, this analysis is based on the assumption that the tax rates will not change over time. If you expect the government to reduce tax rates in the future, this assumption is valid. On the other hand, if you expect the government to increase tax rates in the future, the assumption could be false.

2.2.5.3 Lower tax rate on contributions than the tax rate on withdrawals

Tax rate on

contribution

<

Tax rate on

withdrawal

Asvantage

TFSA

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15

TFSA RRSP

Income before taxes $1,000 $1,000

Income tax (assumption: 40%) $400 $0

Net contribution $600 $1,000

Investment income

(assumption: 20 years at 5.5%)

$1,151 $1,918

Gross proceeds $1,751 $2,918

Income tax on withdrawal (assumption: 45%)

$0 $1,313

Net proceeds $1,751 $1,605

This situation will probably be much rarer than the previous two. However, individuals who have accumulated a substantial estate or high income earners (benefiting from additional plans such as the IPP or a retirement compensation arrangement) may find themselves in this situation.

Since this clientele has strong potential and is highly solicited, you have to perform a complete analysis of their situation before recommending an RRSP or a TFSA.

2.2.6 Withdrawals and Contribution Room

Another major difference between the RRSP and the TFSA concerns the reinstatement of contribution room when withdrawals are made. When a withdrawal is made from an RRSP, the equivalent amount of contribution room is not reinstated. However, the equivalent amount of any withdrawals made from a TFSA is reinstated as contribution room.

This difference underlines the importance of the client's savings objectives. The TFSA is

advantageous for short-term needs (changing cars, travel): no taxation during the accumulation period or on withdrawals. Once the project is completed, the amount withdrawn will be added to the next year's contribution room. Even though an RRSP can be used for a short-term project, this strategy is not used very often. Naturally, the tax deduction increases the amount

contributed as savings, but the taxation of withdrawals can offset this advantage.

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16 Don't confuse the reinstatement of contribution room with the obligation to recontribute withdrawn amounts. To this end, we can use the example of the Home Buyer's Plan (HBP) and the Lifelong Learning Plan (LLP).

The HBP let's first time home buyers withdraw up to $25,000 from their RRSP tax-free, as long as they return the amount withdrawn to their RRSP over a period of 15 years (otherwise they have to add the amount to their taxable income). The TFSA allows individuals to save tax-free and they are not obligated to reimburse withdrawals. This makes the TFSA more flexible, as the amounts are available without a tax penalty.

2.2.7 Eligibility for Different Government Programs

Since the income generated in the TFSA is exempt from taxes, it has no impact on income-based benefits, such as Old Age Security and the Guaranteed Income Supplement. Withdrawals from an RRSP are added to the individual's taxable income and reduces these benefits starting at a certain threshold.

This brings us back to retirement income planning once again. It may be in the interest of individuals who expect to collect a retirement income that nears the threshold for government benefit reductions to contribute to a TFSA in the future, rather than an RRSP.

2.2.8 Collateral Assignment

Contrary to the RRSP, it is possible to assign the assets of a TFSA as collateral for a loan.

However, the interest paid on a loan made to contribute to the TFSA will not be tax deductible.

The advantage of assigning a TFSA as collateral is that you don't lose tax-free growth. However, it will only be profitable if the overall return of the TFSA exceeds the interest charged on the loan.

3 Target Clientele

The best way to summarize everything that has been said so far about the TFSA is to identify what type of clientele it is meant for. Naturally, this new investment instrument is meant for all Canadians, but let's try to target a clientele. The goal is to offer prospecting possibilities, but nothing replaces the need to analyze your client's needs and objectives.

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17 3.1 Affluent Clients

Some people claim that the TFSA is designed "for the rich." At first glance, it appears that they're right.

Affluent clients have the following characteristics, identifying them as individuals with a strong potential to subscribe to a TFSA:

 No debt

 All annual RRSP contribution room used

 Existing non-registered savings

 Probability of a higher tax rate at retirement than during their active life

3.2 Retirees

Retirees who have depleted their RRSP contribution room can now continue to save tax-free with the TFSA.

Retirees who have reached age 71 must convert their registered savings vehicles

(RRSP/LIRA/locked-in RRSP) into disbursement vehicles (RRIF/LIF/locked-in RRIF). Withdrawals become mandatory, but if they are not required to meet budget objectives, these clients can contribute these amounts to their TFSA.

Retirees whose income is higher than or close to the threshold for government pension reductions are hesitant to save because they want to protect their benefits. By contributing to the TFSA, they can now save and not worry about having their Old Age Security or Guaranteed Income Supplement benefits reduced.

3.3 Clients in the Retirement Income Planning Phase

This type of client requires an analysis between use of the TFSA, the RRSP, or a combination of the two. The evaluation of their tax rate at retirement will be the best place for you to start.

Clients who have access to a defined benefit pension plan have their annual RRSP contribution reduced by the pension adjustment. These are high potential clients for the TFSA.

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18 One strategy to consider is to also set aside amounts in the TFSA rather than the RRSP for the first years of retirement, to keep the amounts in the RRSP sheltered from tax for a longer period.

An RRSP/TFSA combination may also be proposed, with the RRSP covering essential needs and the TFSA taking care of special projects.

3.4 Young People

This client segment requires greater analysis. What are the savings going to be used for? The TFSA will likely be more advantageous for short-term projects, such as buying a car or renovating the house.

For longer-term projects, such as acquiring a home, is it preferable to contribute to an RRSP to eventually benefit from the HBP, or is it better to contribute to the TFSA and have the possibility of not having to reimburse the amounts withdrawn?

RRSP contributions for young people who are starting their career are not entirely efficient from a taxation standpoint, due to the tax rate they pay. Is it better to contribute to the TFSA and when the level of income required to maximize RRSP deductions is reached, transfer the amounts from the TFSA to the RRSP? This way, a full deduction will be offered, there will be no tax impact on the withdrawal of amounts from the TFSA, and the amounts withdrawn from the TFSA will be converted into future contribution room.

4 Conclusion

The TFSA is the greatest innovation to encourage personal savings since the creation of the Registered Retirement Savings Plan (RRSP). Even though it will probably get off to a slow start, due to the initial $5,000 limit, you could miss out on excellent opportunities for the future if you don't talk to your clients about it.

Nobody can pass up a tax shelter. Regardless of the client segment or the amount available for savings, the TFSA is an additional option to reduce your clients' tax burden.

References

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