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investor clinic

Investor Clinic has been receiving a lot of questions about the tax-free savings account. Today, I'll answer three of them.

I have been reading some discussions online about an income-splitting strategy involving the TFSA, and I want to know if it's legal. The scenario goes like this:

The husband is a high income earner. The wife has little or no income. In the first year, the husband gives the wife $5,500 to contribute to her TFSA and invest in securities. At year end, she withdraws the securities in kind – all of her TFSA securities go from her TFSA to her non-registered account. The value of the in-kind withdrawal (we'll assume it's still $5,500) is then added to the wife's new TFSA contribution room of $5,500 as of Jan. 1 of the following year, and the husband then gives her $11,000 cash to make a second TFSA contribution. She later withdraws those funds, and so on. If this process is repeated every year, the husband will be able to shift far more money to his wife than if he had simply given her the maximum $5,500 annually to invest in her TFSA. Will the Canada Revenue Agency allow this?

The good news is that you are allowed to give your spouse or partner cash to make a contribution to his or her TFSA. As long as those funds are invested and remain inside the TFSA, there is no tax payable on any dividends, interest or capital gains.

The bad news? If the recipient spouse then withdraws the securities from the TFSA, any future income or capital gains earned would be attributed back to the gifting spouse who was the original source of the funds, said Jamie Golombek, managing director, tax and estate planning, with CIBC Wealth Advisory Services. As a result, "we would not advise this strategy," he said.

In fact, the Canada Revenue Agency specifically addressed this scenario in a 2010 technical interpretation letter, in which it said the exemption to the attribution rules "no longer applies when the transferred property (or any substituted property) is withdrawn from the TFSA."

My wife has about $55,000 in her TFSA, all of which came from her own funds because I did not realize that I could give her money to contribute each year. Can she withdraw the $55,000, and after this amount is added to her contribution room the following year, can I give her a lump sum of cash ($55,000 plus $5,500 in new contribution room) to make the maximum contribution?

This is a bit of a grey area as the CRA has not specifically commented on such a scenario. However, Mr. Golombek suspects it would be allowed because, unlike the first scenario discussed above, none of the funds currently in the TFSA came from the other spouse. In effect, by handing the wife a lump sum, the husband would simply be giving the wife TFSA funds retroactively. "The only way to figure out whether or not this would fly with the CRA is to make a request for a technical interpretation and get the CRA's official position, but it sounds to me like it works," he said.

What is the best investment to hold inside a TFSA? I have read that it is the best place to park short-term cash.

I would disagree with that. The principal benefit of a TFSA is that you pay no tax on interest, dividends or capital gains on securities held inside the account. Many "high-interest" savings accounts currently pay about 1 per cent, which works out to $55 of interest annually on a $5,500 investment. Assuming you are in a 40-per-cent tax bracket, you would be saving yourself all of $22 in tax by parking that money in a TFSA for one year.

There's nothing wrong with that. However, if you have other investments – and you have to choose what to put inside your TFSA and what to leave out – you can potentially achieve greater tax savings by using your TFSA for securities that pay higher interest (guaranteed investment certificates, for example), or dividend-paying stocks that you expect will generate capital gains.

While it's true that dividends and capital gains receive favourable tax treatment in a non-registered account, it's likely that you will still achieve greater tax savings over the long run by using your TFSA for these securities rather than using it to shelter a low-yielding savings account.

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