Tax Managed Strategy 17
Tax-free savings accounts (TFSAs) can be an excellent savings vehicle; however, consideration should be given to who can best benefit from using them, as well as why and how you could use them. Provided you have no credit card debt, TFSAs may be your first choice for contributions to a non-retirement-based account. Here are some things to consider.
Since TFSAs aren’t subject to Canadian tax, it’s generally a good idea to fully utilize them before investing in non-registered accounts. Another consideration, depending on your risk tolerance, would be to put speculative or high-risk investments into a TFSA and hope that a $6,000 deposit grows, for example, to $30,000 or $50,000, which then could be withdrawn tax free. The risk is that if the investment does poorly, capital losses aren’t available to you. Further, you could lose TFSA contribution room if the future withdrawal is less than the original contribution. For example, if your $6,000 contribution declines to $1,000 and you withdraw it, only $1,000 will be added to your future contribution limit, not the original $6,000.
Gradual transfer of other assets
You may want to consider withdrawing funds from other assets, both registered and non-registered and contributing it to your TFSA. Guaranteed interest accounts (GIAs), for example, where the tax on the interest is paid on an ongoing basis, may be a good asset to switch to a TFSA and allow future interest to grow tax free. You may also want to consider transferring market-based assets or even making registered retirement savings plan (RRSP) withdrawals if you’re concerned that you’ll lose income-tested benefits in retirement. The tax paid now may very well offset the impact of reduced benefits in retirement. Remember that if you’re transferring market-based assets in kind to a TFSA from a non-registered account, it will trigger a capital gain or capital loss, and a capital loss would be denied. So, if you’re in a loss position, it may be better to sell the investment and trigger the loss and then contribute the cash to the TFSA.
Every Canadian age 18 and over will have TFSA room but may not have the means to make a TFSA contribution. Income attribution doesn’t apply, so you may want to consider providing the funds to your spouse¹ so they can contribute, thereby increasing the amount of your combined investments that’ll grow on a tax-free basis.
Consider naming your spouse as successor holder of your TFSA. By doing this, the tax-free status of the investment earnings can continue after death.
All provinces, except Quebec,² allow the designation of beneficiaries on a TFSA. If a spouse is named as beneficiary, an amount up to the value of the TFSA at the time of death can be contributed to their TFSA. This contribution wouldn’t affect their TFSA contribution room if it’s done prior to the end of the year following the year of death and is designated as an exempt contribution. However, any income earned between the date of death and the contribution will be taxable to the spouse.
It’s often suggested that, where permitted, the holder name their spouse as successor holder instead of a beneficiary. On the holder’s death, the spouse will automatically become the new holder of the TFSA. The TFSA continues to exist and both its value at the date of death and any income earned after that date continue to be sheltered from tax under the new successor holder. In addition, naming a spouse as successor holder can help avoid the administration and filing requirements necessary to preserve the tax-free status of the TFSA funds when a spouse is named as beneficiary.
Whether naming your spouse as a beneficiary or successor holder of your TFSA, both have the advantage of having the proceeds bypass the estate. In addition, there’s the potential for creditor protection on insurance company-issued TFSAs.
If you have funds earmarked for your children, you may want to consider a gradual transfer of those assets to your adult children now. While this may trigger a capital gain, you can freeze the amount of capital gains paid by having future investment earnings grow tax free, thereby possibly minimizing taxes in your estate later.
A TFSA could be used to supplement your retirement savings if you’re in a situation where you can’t contribute to an RRSP. For example, you may receive dividend income rather than earned income, or you may belong to a pension plan where the pension adjustment limits your RRSP contribution.
A TFSA can’t replace registered education savings plans (RESPs) for education savings because of the grants and the fact that the holder of a TFSA must be at least 18 years old. However, you could provide education savings for your older children—those in university, for example—by providing dollars to contribute to their own TFSA. Alternatively, you could use your TFSA room to supplement the high cost of education when RESP savings isn’t enough.
First-time home purchase savings
With the introduction of the First Home Savings Account (FHSA), first-time home buyers have a great option to save for a home purchase. This is in addition to the Home Buyers’ Plan (HBP), which allows a withdrawal of up to $35,000 from an RRSP. Still, a TFSA remains a flexible alternative (no requirement to be a first-time home buyer) or supplemental savings option. Not only does your TFSA contribution limit begin to accrue when you’re 18 years old, it carries forward, so savings can begin when you choose. Also, you can use a TFSA withdrawal to fund future FHSA or RRSP contributions. Such contributions will be tax deductible and the withdrawals will be added to your TFSA contribution limit the following year.
Strategies by income level
A TFSA may be a great savings vehicle if you’re in a low-income tax bracket. RRSPs may not be well suited to low-income Canadians. If you previously made RRSP contributions and now find yourself in a lower tax bracket, such as when on maternity leave, you may want to consider making a withdrawal from your RRSP to make a TFSA contribution.
One strategy would be to contribute to your TFSA now and accumulate RRSP room to be used later, when in a higher tax bracket, to help optimize the tax benefits. Rainy day or emergency savings would also be appropriate for a TFSA.
This is a situation where you may want to maximize both your RRSP and TFSA contributions. In fact, the tax savings or tax refund received from the RRSP contribution could be used to fund the TFSA.
If you have more income than you need to live on, consider investing the difference in a TFSA. Since you’re already paying tax on it and investing the remainder, why not let it grow tax free? This excess income may be in the form of forced registered retirement income fund (RRIF) minimum withdrawals due to age, or taking Canada Penson Plan (CPP) or Quebec Pension Plan (QPP) income, but still working. It could also be from receiving excess income from mutual fund distributions or from the many investments that provide an income stream that’s primarily a return of capital, such as Series T funds.
Impact on income-tested benefits
Federal income-tested benefits such as Old Age Security (OAS), the Guaranteed Income Supplement (GIS), and child tax benefits won’t be impacted by TFSA assets or withdrawals. Other provincial programs such as disability support, student loans, or nursing homes that factor in assets or income may be impacted. The impact is likely a reduction of such benefits, but this varies by province and program.
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1 Includes a spouse or common-law partner as defined by the Income Tax Act (Canada). 2 In Quebec, the beneficiary of the estate is named in the will and a successor holder can’t be named except for annuity contract TFSAs—like segregated fund contracts and guaranteed interest accounts (GIAs), where a successor holder or beneficiary can be named in the product itself.
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