Tax-Free Savings Accounts have arrived

Beginning in January 2009 all Canadian residents over 18 will be able to contribute annually to a Tax Free Savings Account (TFSA).

For 2009 the limit is $5,000, and although you do not receive a tax deduction for contributing, all income within the TFSA grows tax-free and there is no tax on withdrawals.  In the following years, the annual limit will be indexed to inflation and the annual additions to contribution room will be rounded to the nearest $500.

Nearly everyone should have a TFSA.

Why?  You can save tax-free and still have the flexibility to withdraw your savings at any time, for any purpose.  The new TFSA should be a very important component of all financial plans and investment strategies.  Although initial contributions may be small, it will grow into a substantial amount over time.

Contributions to a TFSA may be the best option for many people, replacing RRSPs as the first place to save money.  Others may find that the TFSA compliments their RRSP savings.  It really comes down to what your taxable income is today and what you project it will be in the future.  A couple who each save $5,000 a year (at the beginning of each year) for 25 years would have combined accounts of approximately $676,000 if the investments earned a seven per cent annualized rate of return.

Nearly every financial firm today has a campaign marketing these new accounts.  Although small at this stage it is important to map out your strategy for the TFSA and how it fits into your overall financial plan.   Here are 10 tips to consider for the TFSA:

1) Financial Plans – The first step prior to setting up a TFSA is to see how it fits into your current financial plan.  After you go through some future contribution and growth numbers you will see that the TFSA will be one of the most important components of your financial plan.

2) Low or High Risk – Many people are torn between choosing conservative cash equivalents and fixed income investments, or choosing higher risk options such as equities.  The underlying investment options are extremely important.   We would encourage people to look at both short-term and long-term goals when choosing investment options.  The choice should be suitable given your risk tolerance, other investment holdings, and cash flow needs.

3) Investment Flexibility – It is likely that the investment you choose may change over time.  Ask the financial institution, where you are considering opening up a TFSA, what types of investment options they have.  It may be that you are limited to savings accounts, term deposits, and/or proprietary mutual funds.  You may find that direct equities, index shares, bonds, or non-proprietary mutual funds are a better option.  If you deal with a firm offering all options, it provides more flexibility this year.  This is especially important if you feel you may want to make investment changes in the future as your TFSA grows.

4) Understanding Fees – Watch for annual fees, transaction fees, withdrawal fees, and transfer fees (if you move your TFSA to another firm).  Some financial firms may have different account options available including transactional, fee-based or managed.  It is important to obtain an understanding of the account type and all current and future fees.

5) Contributions – Not everyone will be able to deposit $5,000 in early January.  Consider contributing $200 as an initial investment in early January then set up a monthly pre-authorized contribution of $400 per month at the end of every month.  This is a perfect pay-yourself investment account.  Care should be taken not to over contribute to your TFSA, as a penalty tax will apply on the excess amount.

6) Beneficiary – Carefully select the beneficiary of your TFSA.  We are encouraging couples to name each other as beneficiary to take advantage of the tax free roll-over.  If you are single, you should obtain an understanding of what happens to your TFSA is you name someone other than a spouse as a beneficiary.  It is possible to name your estate as beneficiary.  However, fees such as executor and probate are often avoided if a beneficiary is named.

7) Withdrawal – One of the most attractive components to the TFSA is that it may be replenished if a withdrawal is made.  Some restrictions apply relating to replenishing a TFSA in the same tax year.  We envision multiple reasons why someone would need to make a withdrawal, such as: education expenses, home purchase or renovation, vacation, health care expenses, car purchase, etc.  Another reason a person may make a withdrawal is to shift funds into an RRSP.  If you are in a low income tax bracket, it likely makes more sense to contribute now to a TFSA.  If in the future you are in a higher income tax bracket (making greater than $38,000 annually), and can commit the funds for retirement, it may make sense to roll some funds from your TFSA into your RRSP to obtain a tax deduction.

8) Low Income Years – The TFSA will immediately benefit seniors who are currently receiving income-tested benefits and we encourage those with low incomes to take full advantage of the TFSA.  Higher net worth individuals may consider using the TFSA for withdrawals to fund the first few years of retirement.   As an example, a person could have $500,000 in an RRSP at age 65 and $300,000 in a TFSA.   By using the TFSA for the first five years it may be possible that you will also receive income tested benefits (i.e. guaranteed income supplement, old age security) provided the rules do not change.

9) Sheltering Income – If you follow Tip 8 then chances are you have the ability to contribute funds back into your TFSA when you begin pulling funds out of your RRSP and RRIF accounts.  Although the RRSP and RRIF withdrawal is taxable, the proceeds may be deposited into the TFSA to tax shelter the future investment income component.

10) Talk To An Advisor – We encourage you to speak with a financial advisor to discuss opening a TFSA.   An advisor should obtain an understanding of your cash flow needs, taxation matters, goals, and risk tolerance.  With this knowledge they should be able to guide you in the right direction.