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The right way to use a Tax Free Savings Account

By now, you may have read that the Department of Finance tweaked the rules around Tax-Free Savings Accounts (TFSAs) on Oct. 16. Most Canadians won't be impacted by the changes because they were meant to shut down some tactics used by a few sophisticated investors trying to squeeze more out of TFSAs than the government intended.

The first tactic being shut down is the deliberate over-contribution where an investor would put significantly more into the TFSA than permitted, face a one per cent penalty per month on the excess, but hope to make much more than the penalty in profits on something high-risk like junior mining penny stocks. After the rule change, 100 per cent of the gains or income on the excess amount will end up in the taxman's pocket.

Next, the government wanted to shut down asset transfers from RRSPs and other registered or non-registered accounts. It was possible to shift value from, say, an RRSP to a TFSA by making frequent transfers and exploiting small gains in asset values. The rule change will cause a penalty equal to 100 per cent of amounts in the TFSA reasonably attributed to these transfers.

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The last change made by the government has to do with prohibited or non-qualified investments. Seems that some folks were making these investments, paying the penalties that apply, but aimed to earn large gains that would remain in the TFSA even after withdrawing the non-qualified investments. Under the new rules, any gains on prohibited investments will be taxed at 100 per cent, and any income on that income from naughty investments will be taxed at regular rates (same as interest income).

In addition to all this, any withdrawals of excess contributions, transferred assets, and prohibited or non-qualified investments will not count as distributions from a TFSA, and therefore won't give rise to additional TFSA contribution room.

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TFSA strategies

So all of this leads to the question: How can TFSAs be used most effectively in your tax planning? Consider the following ideas:

1. Shelter taxable income. You'd do well to earn certain highly taxed income inside your TFSA where that income won't face tax. I'm thinking of interest income, certain options strategies or short-selling of securities (which can give rise to regular income), or foreign dividend income which is not eligible for the dividend tax credit. So, plan carefully which investments to hold in a TFSA.

2. Split income with your spouse. Simply giving money to your spouse to invest doesn't generally work to save tax because the attribution rules in our tax law will cause the income to be taxed in your hands instead. You can, however, give money to your spouse to contribute to a TFSA without concern that any taxable income will end up in your hands.

3. Trigger tax losses. If you're thinking of selling a security that has dropped in value in order to use the capital loss, but you like the future prospects of the investment, consider selling the security outside your TFSA, then contribute the cash to your TFSA and repurchase the investment inside the TFSA. The future growth of the investment will be tax sheltered.

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4. Smooth fluctuating income. If your income fluctuates over time, consider contributing to your TFSA and make withdrawals from the TFSA to contribute to your RRSP in years when you might need an added deduction to reduce your taxable income, or withdraw funds from the TFSA in a lower income year to supplement your earnings.

5. Minimize clawbacks. By investing in your TFSA you can shelter future income on those assets so that it will not have to be reported on your personal tax return. This will reduce your taxable income and thereby reduce the impact of any potential clawback of Old Age Security or similar income-tested government benefits.

6. Help your children. If you're thinking of helping your kids with a major purchase, consider giving them money to contribute to their TFSA where it can compound tax free. You may also want to structure this as a loan, properly documented, to protect the assets from the potential breakdown of your child's marriage.

7. Draw from your TFSA first. When it comes time to make withdrawals in retirement, consider drawing down your TFSA assets first since those withdrawals are tax-free, and this can defer taxable withdrawals from your registered plans until you have to make those withdrawals under the minimum withdrawal rules or otherwise need the cash.

8. Create emergency savings. Set aside between three and six months of living expenses in a TFSA over time if you can.

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About the Author
Author and founder of WaterStreet Family Offices

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices. More

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