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tax-free savings accounts

Structuring your portfolio to hold the most highly-taxed investments in a TFSA or RRSP will reduce the tax owing for the 2013 tax year.Getty Images/iStockphoto

For a growing number of Canadians, the legacy of late federal Finance Minister Jim Flaherty will be the introduction of the tax-free savings account.

He rolled out the TFSA in the wake of the 2008 global financial meltdown to help give shell-shocked retail investors faith in the capital markets. Since then, Canada Revenue Agency reports that more than 10 million TFSAs have been opened, with a total value exceeding $88-billion.

It's been a slow climb to popularity since 2009, when the initial maximum contribution was $5,000. Each year the total contribution limit has been increased by at least an additional $5,000. Canadians can now invest up to $31,000 in their TFSAs without ever being taxed on the gains.

"If the rules were to stay the same it is a no-lose type of program – at least from a tax standpoint," says Myron Knodel, director of tax and estate planning with Investors Group in Winnipeg. He says that with Ottawa's plan to boost the contribution limit by an additional $5,500 plus inflation each coming year, it's just a matter of time until more Canadians wake up to the wonders of tax-free investing.

"I think it's going to take more time for people to get educated on how it really works," Mr. Knodel says. "It's still a mystery to a lot of people, and there is a certain amount of skepticism in general when the government comes out with a new program."

Some of that skepticism could be well founded, according to Mr. Knodel, who fears the TFSA could become a victim of its own success. As more Canadians sign on, the lost tax revenue will take a greater toll on government coffers just when an aging population makes more demands on the public purse.

"There's always the risk that the law today may not be the same tomorrow," he says. As an example, he suggests entitlements for Old Age Security could be clawed back if Ottawa decides to include money from a TFSA as income for retirees.

The federal government has made no commitment to how long the contribution limit will be increased each year, and it's not certain the next government in Ottawa will even keep the TFSA alive.

For now, he says, the tax advantages from a TFSA far outweigh those of a regular, non-registered investment account. Outside a TFSA, half of the capital gains reaped from stocks or funds that hold equities are taxed.

Dividends from stocks are fully taxed, but qualifying equities generate a small dividend tax credit that can be applied against the tax.

Worst of all, income from bonds or other interest-bearing securities held outside a TFSA are fully taxed.

For that reason, TFSA investors should give first priority to the securities that provide the most tax efficiency, Mr. Knodel says. "Probably something that earns interest, because interest is 100 per cent taxable."

However, he says there are exceptions to that rule. Investors with a high tolerance for risk can realize far larger tax savings in a TFSA if a stock skyrockets in value.

"If you think you have a home-run stock in your TFSA your advantages will be significant because you won't be taxed on any of that gain," he says.

On the downside, any capital losses in a TFSA cannot be used to offset capital gains from other investments, as is the case in a non-registered account.

A tax-free savings account even has several advantages over the cherished registered retirement savings plan. Although RRSP contributions are initially exempt from income tax, those contributions – and any gains they produce over the years – are fully taxed when they are withdrawn.

Any tax savings in an RRSP comes from deferring taxation to a point in the future (ideally retirement) when the plan holder is in a lower tax bracket.

Transferring securities into a TFSA

As TFSAs increase in popularity, more Canadians are looking to shelter gains on securities they already own in non-registered accounts.

The process is known as an in-kind transfer, and it involves settling up with CRA by paying the tax on capital gains up to the point of transfer. It's like paying a parking attendant before moving your car to a free parking spot.

"If there's an accrued gain on those investments, when you transfer it into a TFSA you're deemed to have disposed of it for its then-fair-market value. It would be just like you sold it on the open market," says Mr. Knodel.

Unfortunately, in the case of in-kind transfers a capital loss cannot be used to offset a capital gain.

If the investor wishes to take advantage of a capital loss, or dump the stock for any reason, Mr. Knodel suggests selling the investment before the transfer and contributing cash to the TFSA.

There is, however, a catch if the investor wants to continue holding the security. If it is repurchased within 30 days it is considered a superficial loss and a capital loss cannot be claimed.

"You would have to sell your investment, wait 30 days, and then repurchase it within the TFSA. In that scenario that loss can be deducted against other capital gains," he says.

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