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tax-free investing

Finance Minister Jim Flaherty speaks to reporters in 2008, the year he introduced the Tax-Free Savings Account.GEOFF HOWE/The Canadian Press

When Finance Minister Jim Flaherty introduced the Tax-Free Savings Account (TFSA) to Canadians in his 2008 budget speech, he hailed the tool as "the single most important personal savings vehicle since the introduction of the RRSP.

Nearly five years later, it hasn't quite worked out that way.

A CIBC-Harris Decima poll conducted last year found that 47 per cent of Canadians reported having a TFSA, but among those who did, only 47 per cent had contributed to the vehicle that year. Fully 41 per cent reported that they lack plans for their TFSA-invested funds.

"Remarkably, all the stats show [TFSAs] are still being underused," explains Matthew Bacchiochi, vice-president at Toronto-based financial planning firm Gavin Private Counsel. "It's still an education process."

So, why have so many Canadian investors given TFSAs the cold shoulder?

"I think initially they didn't garner a lot of attention because it was a relatively small amount of money for a lot of people," explains David Stewart, a principal at Toronto-based Stewart and Kett Financial Advisors, Inc.

In addition, Mr. Stewart notes that younger savers – particularly in cities with hefty home prices such as Vancouver, Calgary and Toronto – often lack the available funds to pay a costly mortgage, top up TFSAs, maximize other investment contributions and build the emergency savings funds that virtually every financial planner calls a necessity.

Others are often stuck paying down consumer debt such as credit card balances. Saving for TFSAs, in other words, has become a secondary priority for many.

That may soon change.

As of Jan. 1, the annual TFSA contribution limit jumped to $5,500 from the original $5,000 with further increases likely on the horizon. Industry insiders say more savvy savers have begun viewing their TFSA – which is often described as a bucket into which Canadians can drop a fixed amount each year that can be invested in everything from bonds to stocks, then withdrawn tax-free and replenished up to the cumulative annual contribution allowance – as an increasingly important savings tool.

"I think we're seeing a bit of momentum gathering [around TFSAs] as contribution room or opportunity increases each year," says David Lloyd, a managing director with Toronto-based investment management firm Newport Private Wealth.

The challenge for those eager to effectively leverage their TFSA may be the simple lack of a strategic rule of thumb. That's because each investor's approach will vary widely based on variables unique to them, from their age to income to tax circumstances.

What most financial planners advise is that TFSAs make for a better conservative, rather than aggressive, investment tool thanks to their ability to generate more income, compounded over the long-term and with no tax liability.

They also stress that TFSA contributions should be co-ordinated with other investment strategies, particularly for the vast majority of Canadians with limited financial resources who struggle with the annual decision to contribute to their TFSA or invest in other vehicles such as Registered Retirement Savings Plans (RRSPs) or Registered Education Savings Plans (RESPs).

In many cases, and depending on an investor's income and tax situation, leveraging the tax benefits of RRSPs can offer immediate advantages that exceed those offered by TFSAs. So, too, can the free grants provided to parents who use RESPs to save for their children's education.

That said, TFSAs still offer major financial benefits. Here's a few examples of how they can be leveraged by investors at different life stages:

20s – The post-university years

While 20-somethings should open TFSAs to maximize contribution potential in future years, they may still be in school or struggling to repay student loans, making serious saving a near impossibility. "[Contributing to a TFSA] is less important at this stage," explains Mr. Stewart. "If it's a choice between buying a house or not, it's not going to get done." The one advantage, he adds, is that unlike RRSPs, TFSAs have no income requirement. Any Canadian citizen older than 18 can invest $5,500 per year without conditions, then withdraw their capital and tax-exempt investment earnings at will. That provides added flexibility for younger savers with lower incomes. The advantage for those who do have the funds to save at this early stage: reaping the benefits of years of compound interest and investment growth.

30s – The child-rearing years

By this stage most Canadians will (hopefully) have paid off their student debts, have a (somewhat) defined career path and a stronger annual income. Looks like they're ready to start maximizing those TFSA savings, right? Not so fast. They've likely bought a home and have acquired a hefty mortgage along the way, not to mention costs related to home maintenance and other expenses such as a car. Then there's the tiny new additions to their family who might be sapping income for everything from diapers to daycare – dollars that would otherwise go into savings and investments accounts. "At this stage, TFSAs are primarily for short-term contingency funds or as an accumulation pool for major expenditures," says Alan Kotai, a portfolio manager with Vancouver-based Rogers Group Financial Advisors Ltd.

40s – The wealth-accumulation years

As Mr. Lloyd explains, many investors in their forties have paid down their student or consumer debts and are beginning to focus on building savings and a retirement nest egg. They may also be inheriting money from parents or other family members that allow them to maximize RRSP and RESP contributions, and possibly even pay down mortgages. "Topping up TFSAs makes more sense in that case," he says. "Typically it's not top of mind for people with other priorities, but if there is going to be transfer of wealth and as TFSA contribution limits increase, those [compounded growth] numbers add up."

50s and older – The empty-nest retirement years

For many Canadians in their fifties, their kids may have moved out and they're likely in their peak earning years, so any financial planning strategy should focus on retirement savings, according to Mr. Kotai. At this point TFSAs are "primarily for retirement and long-term contingency funding [such as potential medical expenses in the future]."

But regardless of how they're used at different ages, the question remains: should investors regard their TFSA as a long-term retirement savings tool, or merely a rainy-day fund to be used for everything from emergency to vacation expenses?

"The RRSP is the best retirement vehicle because the government is subsidizing your contribution and it should be put away for a long period of time before you have to pay tax on its income," Mr. Lloyd explains. "With a TFSA, there's no downside for taking money out, so it's a good emergency fund."