Tax Free Savings Accounts
The Tax Free Savings Account presents some interesting possibilities from a planning point of view. It does not replace the RRSP but instead should be used to enhance RRSP savings. It can be used for short term savings unlike RRSP’s but also can be used for long term savings.
My feeling is that the investment vehicle of choice should offer no cost (or very little) and your capital investment should not be at risk. At first glance this might limit choices but the tax free status of the earnings makes interest bearing investments more attractive than previous.
As an example mutual funds already enjoy a tax advantage over GIC’s. A mutual fund will produce a capital gain or loss – the gains taxed more advantageously than GIC’s. Dividend funds also enjoy tax advantages over GIC’s. A taxpayer in Alberta will currently pay 39% tax on GIC earnings (the maximum marginal rate in Alberta). Beginning in January 2009 that same taxpayer will not pay income tax on his or her TFSA earnings. In other words a 5% return on a GIC (or some other type of interest earnings) inside a TFSA will enjoy a real rate of return of 5%. Previously, the above taxpayer would have paid just a little less than 2% income tax for a net return of 3% (assumes a 5 year GIC rate of 5%).
Market investments such as mutual funds usually use an 8% net return for projections. Even with the capital gains tax status of these funds one should carefully compare the risk versus the reward of a GIC type investment (inside a TFSA) versus the riskier mutual fund type investment. Is the 5.5% annually compounded guaranteed net return on a 5 year GIC TFSA versus the 7.5% net return on a mutual Fund (average 8% per year for 5 years less tax at Alberta’s top rate) worth the risk? When GIC’s had no special tax status (i.e. TFSA) it seemed like an easy choice. To gain any chance for capital appreciation a mutual fund (in this interest return environment) was at the head of list. Now the choice is not so clear, especially in short term savings goals (up to 5 years). The TFSA (inside one of the current daily interest savings accounts available) is completely liquid and the earnings are non taxable. Cashing in a mutual fund (although usually liquid) is often subject to a deferred sales charge plus capital gains tax.
I have not yet reviewed any tax implications of a loss inside a TFSA. For instance a capital loss in a mutual fund can be used to offset any other capital gains. The tax free status of a TFSA will likely negate losses against gains making the choice of investment vehicle for your TFSA very important.
Red Adair had a favourite quote: If you think hiring a Professional is expensive ‐ wait until you hire an amateur.
James Kew is a Financial Planning Professional in Sherwood Park at 1‐800‐810‐7526. All Financial Planning advice should only be undertaken after consultation with a Financial Planner who is a member of Advocis or the Canadian Association of Financial Planners.