What are the benefits of a tax free account (TFSA)?
The Tax-Free Savings Account is just like an RRSP in one respect and gains compound tax-free while they’re in the plan.
It’s different in two ways: First, there is no tax deduction for putting money into a TFSA, as there is in an RRSP. “With a TFSA, the money invested is after-tax money,” says the advisory. “With an RRSP it’s pre-tax money that you are investing.”
The other big difference is that money taken out of a TFSA will not be taxed at all, no matter how much the funds have grown. With an RRSP, every cent you withdraw is taxed as ordinary income, even if it came from dividends or capital gains.
Now let’s see exactly what you are getting with the new TFSA.
Spelling it out
The advisory spells out this new savings plan, detail by detail:
• As of 2009, any Canadian of age 18 or older will be able to invest up to $5,000 per year in a TFSA.
• No taxes will be payable on any investment gains, including capital gains.
• The money in the TFSA can be withdrawn at any time.
• Any funds that are withdrawn can always be put back into the account at a later date without reducing contribution room.
• Any unused contribution room for any year can be carried forward to a future year.
• There is no lifetime contribution limit.
• A person may also contribute to a spouse’s TFSA.
• Assets from a spouse’s TFSA account will be transferable upon death to the other spouse without tax implications.
The advisory sees two big positives in this plan. “First of all, Canada’s savings rate is both dismal and declining, so anything that reverses this trend is welcome in the sense of general economic health.
“Second, knowing that you will never be taxed has a certain appeal.”
But there are three drawbacks that must be noted, in this advisory’s opinion.
Fees, deductions and tax brackets
The first drawback is the contribution limit of $5,000 and how much of that will be eaten away in fees. “It remains to be seen how much the banks and other financial institutions will charge to administer one of these accounts (RRSP fees generally run from $60 to $120 a year),” says the advisory, “but in the first year especially that fee will cut significantly into your return.”
When the account balance gets to $10,000 or $15,000, the fee will constitute a lesser percentage, of course, but it still erodes your return. This also happens with RRSPs, of course, but in most well stocked accounts, the fee takes a much smaller bite.
Next, capital losses won’t be deductible against capital gains. If you lose money in a TFSA, there is no tax cushion to offset it.
Finally, there is this to consider. It’s quite possible that you could be in a significantly higher tax bracket when you put the money into a TFSA than you are when you take the money out. “While contributing to an RRSP under these circumstances would result in a net tax reduction, doing so with a TFSA would actually result in higher net taxes being paid.”
When you consider how the value of your investment compounds, it makes this scenario even less palatable, adds the advisory.
“Don’t get us wrong,” concludes the advisory. “We like the concept of a TFSA. Just know that there are some caveats to it as well.”