The tax-free savings account (TFSA) has been around for more than a decade, but advisors should still be talking to clients about the pros and cons of the investment vehicle and how it can best be used to achieve their financial goals.
A recent Bank of Montreal survey shows many Canadians aren’t maximizing the benefits of a TFSA as 38 per cent said cash was the primary investment in their TFSA, treating it more like a piggy bank, followed by mutual funds at 23 per cent and stocks at 18 per cent.
“For a TFSA to be worthwhile, you have to make money to save taxes,” says Sylvain Brisebois, senior vice-president and managing director, national sales manager, at BMO Private Wealth in Ottawa.
The survey also shows about a quarter of Canadians aren’t aware of what investments are eligible in a TFSA. As such, Mr. Brisebois says the financial services community, at large, needs to do more to educate investors on how to use – and not use – a TFSA.
“The investing public requires us to be more proactive,” he says. “We are investment advisors, but we are also investment educators ... If the industry is going to have a good reputation, we have to be mindful of how we can serve the investing public.”
Here are five lesser-known facts about TFSAs advisors should discuss with clients:
1. Use it for income splitting
One benefit of a TFSA is its use as an income-splitting tool to lower the family’s overall tax bill, says Evan Turner, a financial advisor at Nicola Wealth Management Ltd. in Kelowna, B.C.
To make it effective, a higher-income spouse can give money to a lower-income spouse to use to contribute to the lower-income spouse’s TFSA. The higher-income spouse doesn’t get a tax deduction, as he or she would with a spousal RRSP, for example. Still, the benefit is the income earned on the money invested in a TFSA isn’t taxed.
“It’s a great way to get money into your spouse’s hands without attracting income attribution to the higher-earning spouse,” while also investing more tax efficiently, Mr. Turner says.
2. Keep it Canadian
The origin of assets held in a TFSA is also important, Mr. Turner says. For example, unlike in a registered retirement savings plan (RRSP), dividends from some foreign investments in a TFSA, such as U.S. stocks, will be subject to a foreign withholding tax.
“To get the most bang for your buck, it’s an advantage to hold Canadian-based investments in your TFSA,” he says. “Better yet, high-yield, interest-bearing investments get some of the best tax advantages being held in a TFSA.”
Investors should also be made aware that they can contribute foreign funds to a TFSA, but the amount can’t exceed their TFSA contribution room when converted to Canadian dollars.
3. Keep it eligible
Not all investments are eligible to be held in a TFSA, such as over-the-counter stocks. Generally, investments permitted in a TFSA are the same as those allowed in an RRSP, such as mutual funds, exchange-traded funds, guaranteed investment certificates (GICs), bonds and certain shares of small business corporations.
Investors that add non-eligible investments will likely face steep financial penalties, Mr. Brisebois says.
“You also don’t want to get caught putting non-authorized investments in there because you will also have to get rid of them,” he adds.
4. Proper ways to withdraw and reinvest assets
Advisors should ensure clients understand the pros and cons of pulling money out of a TFSA and putting it back in, says Jeet Dhillon, vice-president and senior portfolio manager at TD Wealth Private Investment Counsel in Toronto.
“Whatever you take out is what you get to put back in the following year,” she says, noting that includes gains.
So, if an individual was at least 18 years old and eligible to open up a TFSA when the investment vehicle was introduced in 2009, the maximum contribution room for a TFSA as of this year is $75,500. Someone whose TFSA has grown to $100,000 can pull out that full amount and put the entire sum back in the following calendar year.
“It’s another good benefit [of the TFSA],” she says.
However, if the same contribution dropped to $50,000 and the investor pulled out that full amount, Ms. Dhillon says the individual would only be able to put $50,000 back into the TFSA.
Advisors also need to remind investors that they will pay taxes on investments they pull out of an RRSP or a non-registered fund (if there are capital gains in the latter) to contribute to a TFSA, she adds. It’s only money withdrawn from a TFSA that’s tax-free.
5. Successor or beneficiary?
For estate planning purposes, investors may not realize they have two options when deciding to leave their TFSA to a spouse – naming the as a successor or beneficiary.
Mr. Turner says naming the surviving spouse as a successor is best. That’s because when a spouse dies, the surviving spouse becomes the “successor” holder and the investments can continue to grow and then be withdrawn tax-free. He adds that only spouses, which includes common-law partners, can be named a successor of a TFSA.
A surviving spouse named as a beneficiary could pay taxes on any income earned in the TFSA after his or her spouse’s death. However, the surviving spouse does have the option to add it to his or her own TFSA without affecting their unused contribution room. The surviving spouse can make this so-called “exempt contribution” by filling out the Canada Revenue Agency’s Form RC240 within 30 days after the contribution is made.
The rules are complicated (and are different in Quebec), which is why Mr. Turner recommends advisors discuss them with clients – along with other considerations that affect their investment objectives.