Understanding tax-free savings accounts

Atax-free savings account (TFSA) is a new wrinkle for savers, and most tax advisers though not all say putting money into a tax-free savings account is a no-brainer for people who can afford to save.

Starting in 2009, any resident of Canada over the age of 18 can put up to $5,000 a year into a tax-free savings account. That amount will be indexed to inflation, so it will grow in future years.

A TFSA has some of the features of a registered retirement savings plan (RRSP) income earned inside a TFSA is not taxable, although you won't get a tax refund for the amount invested the way you would for an RRSP contribution. Tax-free savings accounts also have few of the drawbacks, since the money can be taken out tax-free at any time.

"Opening a tax-free savings account (TFSA) can offer you and your family the opportunity to earn a significant amount of investment income tax-free," says a KPMG Canada note to its clients. "Though your contributions to this new type of tax-assisted savings account will not be tax-deductible, the investment income and capital gains earned on investments in the account will be tax-free. You'll be able to withdraw this income and your contributions to your TFSA at any time without tax consequences."

You can hold the same things inside a TFSA that you can in an RRSP: cash, guaranteed investment certificates (GICs), term deposits, mutual funds, government and corporate bonds, stocks traded on public exchanges, and shares of some small business corporations.

"The kind of product you put inside your tax free savings account is really dictated by what you already hold in your RRSP and your regular savings," Kurt Rosentreter, a financial adviser with Manulife Securities, told CBC News Business."Generally I would suggest, because of the tax-free nature of the income, that you would put your highest-tax forms of investments like GICs, bonds and regular bank account cash [into a TFSA] and shelter that first," said Rosentreter.

Stocks held outside a tax-free account, for example, qualify for lower tax rates on dividends. If you have losses on stocks, you can deduct those losses against previous capital gains if you hold them outside a registered plan, but not if they are in a tax-free savings account.

If you don't make a contribution in 2009 you can carry forward that amount to the next year. So if you don't make a contribution in the new year, in 2010 you'd be able to contribute up to $10,000 (assuming the contribution limit remains the same next year). This carry-forward feature goes on indefinitely.

There are no upper age limits for holding a TFSA, either, as there are with RRSPs.

"I think for retired Canadians this is a great way to tax shelter more of their investment income, transferring some of their taxable investments into a tax-free savings account," says Manulife's Rosentreter.

He points out that another advantage for retired people is that tax-free withdrawals don't bump them into a higher tax bracket, where things such as Old Age Security payments are clawed back.

Caveats

Not everyone thinks the new tax-free savings account is the greatest thing since the invention of the RRSP, though. "I'm puzzled by why so much ink has been spilled on the TFSA," says Moshe Milevsky, a professor at the Schulich School of Business at York University and author of several books on personal finance.

"Let's do the math. You get to save $5,000 assuming you have any money to spare in the recession without paying tax on the gains made during 2009. Assume this money is sitting in GICs, since everyone is petrified of putting money in the stock market, and that rates are 4 per cent, assuming the Bank of Canada doesn't march us to zero.

"That leads to $200 of interest for 2009, which is tax-free. Yippee. At a 45 per cent marginal tax rate, that saves me $90 in taxes. In 2010 it might save me $180 in taxes, and then in 2011 it's worth $270, give or take some compounding."

While the government didn't plan the tax-free savings account as part of its overall recession package it was introduced in the spring 2008 budget Milevsky says the recession has left him and other investors with less money but lots of tax losses from failing investments.

"Ironically, I have realized enough capital losses this year to spare me from a lifetime of capital gains taxes. The bear market created my own personal TFSA," he says.

In spite of his misgivings, the new tax-free savings accounts are expected to be popular with savers. They will also be popular with the financial institutions that will be handling the money.

The account can be set up at a credit union, bank, brokerage house or other financial institution. Prepare for an RRSP-style avalanche of advertising aimed at enticing people to open these accounts. Perhaps the best idea is to go with the firm already handling your savings as long as their fees are reasonable.

Fred Langan is host of CBC News Business.