February 28, 2008, 7:00 am

The Tax-Free Savings Account (TFSA) – A Creative Financial Approach

by: The Financial Blogger    Category: Personal Finance
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The Canadian Government deposited their 2008 budget this February 26th. So at the same time that the Montreal Canadiens were showing their inability to be creative enough to bring Marian Hossa (!) in our team, the Canadian Government were including a nice innovation called the Tax-Free Savings Account (TFSA) in their 2008 budget. This measure will take effect as of January 1st 2009.



What is the TFSA?

The TFSA is an account where you can put money (up to $5,000 per year per person) and all gains (interest income, dividend and capital gains) are non taxable. Even better, you can withdraw the money from your account at any time under no restriction and without being taxed on the amount of the withdrawal.

You can save up to $5,000 per year and unused TFSA contributions room can be carried forward to future years. You can also contribute to your spouse and benefit from income splitting strategies.

As previously mentioned, you can withdraw money at any time from your TFSA and this does not affect your contribution room. You always have the possibility to put back the money into the Tax-Free Savings Account at any time without any penalties.

Comparison between an RRSP and a TFSA

At first, the RRSP and the TFSA could look alike. However, when you take a moment to analyse both of them, you will find several differences. I completed the following chart to help you out determining which account is best for your personal finance.

RRSP

TFSA

Minimum age to start contributing

No minimum. The individual must declare income.

Minimum age of 18.

Maximum amount of contribution

$19,000 or 18% of declared income. The maximum amount is increasing year after year.

$5,000 per year.

Contribution is tax deductible

Yes.

No.

Investment gains (interest, dividend and capital gains) are not taxable

Yes.

Yes.

Spousal contribution are permitted

Yes.

Yes.

Withdrawals from the account are taxable.

Yes. They are not taxable in a case of a Home Buyer Plan and to go back to school (those 2 programs work under certain restrictions).

No. Withdrawals from the TFSA are not taxable.

Unused contribution room can be carried forward.

Yes.

Yes.

You can “reimburse” your withdrawal in the account.

No. You can only reimburse under the HBP and return to school program under certain restrictions.

Yes. You can reimburse your withdrawals from the TFSA at any time without penalties.

According to Million Dollar Journey the account would not serve the Smith Manoeuvre Strategy since the interest paid on the borrowed amount would not be tax deductible. He took his information from The Financial Post. I will go deeper into this as it would simply be amazing to combine the Tax-Free Savings Account to a Smith Manoeuvre Strategy.

If you are looking for more information on the TFSA or the 2008 Canadian Budget, I suggest you read those articles:

Million Dollar Journey

Canadian Capitalist

The Globe and Mail

Fours Pillars

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Comments

Hey FB, thanks for the mention. It’s too bad that borrowed interest wont’ be tax deductible with this account, however, it’s still a great account regardless. So many possibilities!

[…] Capitalist Million Dollar Journey Canadian Dream Financial Jungle The Financial Blogger Canadian Mortgage […]

Thanks for the link FB. FT is right. The budget specifically mentions that borrowing to invest in the TFSA is not tax deductible.

Is the smith manouvre really that profitable? Doesn’t it just convert your mortgage into an investment loan so you can tax-deduct the interest? Typically you can get a mortgage rate that is cheaper than the prevailing HELOC rates, so much of what you gain in a tax savings is lost to the higher rate. The timing of when you lock into your mortgage might make a difference.

I did the calculations on converting my own mortgage in the past, and the amount of the return was very small. In general though, borrowing to buy investments is way better than borrowing to buy consumption.

by: The Financial Blogger | February 28th, 2008 (8:20 pm)

FT and CC;
That’s too bad for the SM! I guess I’ll have to wait and pray to have the tax exemption on the capital gain next year!!

CR;
I am a firm believer of leveraging based on the power of compounding interest. Many financial institution (including the National Bank starting this April) allow you to combine a fixed mortgage with a HELOC. On the other side, it has been mathematically proven that if you take the variable mortgage rate over 25 years, you will end up paying less interest than renewing a fixed rate every 5 years.

I was thinking about this again. Please correct me if I’m wrong, but I think it might actually be useful for the Smith Manouvre Investments. Not on the front end but on the back end.

It is difficult to say exactly until the TFSA comes into play but here is an idea, if transfers in kind are allowed. If we are able to do a “transfer in kind” of non-registered funds into a TFSA closer to retirement in order to avoid taxation and wash non-registered funds like those of the Smith Manouvre before we actually need it. Just say your a couple and want to retire in 10 years, so you together have 100,000 of TFSA room, you transfer in kind from the non-registered funds of the SM – then withdraw funds from the TFSA to avoid taxation and create room again to do it again the next year? That would mean that a couple who needed $100,000 before tax could now only need to save $70,0000 – since there would be no tax on the money from the TFSA.

I also mentioned this over at Canadian Dream- http://blog.canadian-dream-free-at-45.com/?p=364#comment-3800 but haven’t got a response yet. I’d appreciate some FPs opinions on this.

by: The Financial Blogger | March 1st, 2008 (5:50 pm)

Quentin;
I guess it would work but you would lose your tax deductibility advantage at that point. I think it could be a could way to end-up the Smith Manoeuvre when you are about to retire.

I would suggest we wait until next year and speak to an accountant 😉

CRA will allow transfers in-kind to the TFSA but will consider it a disposition. So you will be forced to realize a taxable capital gain using the asset’s market value at time of transfer. Hence no wash. “In-kind” only means you get to hold on to the asset, not that you avoid taxes.

let’s just hope the politicians a little further south pick up on this idea.

The U.S. has had the Roth IRA since 1997 as a tax-sheltered retirement savings vehicle, so Canada was way behind on this. But now Canada has leap-frogged ahead with the TFSA: contribution room isn’t “use it or lose it” (it’s carried forward indefinitely) and it offers complete withdrawal flexibility.

[…] The Financial Blogger compares TFSA with RRSPs. […]

[…] the Canadian Government’s create of the Tax-Free Saving Account, many bloggers wrote their thoughts about it. I did a comparison between the RRSP and the TFSA in […]

[…] to buy your house in 12 to 24 months, you are better off with an investment account. With the TFSA (Tax Free Savings Account created by the government, it will be easier to get a decent yield without being taxed on it. For […]

After re-reading this article what amazes me the most is that DESPITE The Financial Blogger and other reputable sources that have been talking about the TFSA since at least the first quarter of 2008, yet most Canadians STILL have NO Clue as to what it is and how it works. More people need to utilize all the financial tools available at their disposal.

[…] of January 2009, you can contribute up to 5K per person per year into a Tax Free Savings Account (TFSA). This won’t give you any money in returns, but will allow your investment to grow tax […]

Do investors think they should put their higher or lower earning investments into a TFSA? Some consultants are saying to put investments such as GICs into a TFSA because they are taxed at the highest rate (as interest income). This makes sense mathematically, but who wants their TFSA to grow at only 3 or 4%?

I have been think a lot and reseaching what to invest in using my TFSA. After much careful analysis I find that an investment that has high dividends, is tax inefficient, and relatively low risk should be used in the TFSA. In the following article, http://investcanada.blogspot.com/2009/08/tfsa-tax-free-savings-account-best-tfsa.html, you can see why income trusts should be used.

[…] August this week and you haven’t opened your TFSA account? What are you waiting for? The TFSA (Tax Free Savings Account) has been in place since the beginning of 2009, sponsored by the Canadian Government. While I had […]

[…] next thing I am going to do is open a tax-free savings account. I will go into more detail on these accounts in a later posting but essentially, each individual […]