Tax Free Savings Accounts explored
TFSAs have now been around for 4 years – introduced in 2009. Let’s look at the background for their introduction. The Canadian and world economies had just been through a major collapse in 2008. People were pulling money out of capital markets. With money removed from markets, investment capital became very scarce. Our Federal Government needed to do something to get people investing again – TFSAs were their solution.
But why create something new? We already had a couple of special tax-preferred plans available – RRSPs and RESPs – what was different? Much public (and Opposition Party) opinions were that RRSPs really benefitted upper-middle class and wealthy Canadians so raising the annual limit wasn’t very politically palatable. The same feelings applied to RESPs. So something new was needed.
Enter the TFSA. Conceptually, it treats all Canadians equally – the maximum annual contribution limit is a flat $5,000 and it is a cumulative limit. Miss a year, or only make a partial contribution, the unused portion is carried-forward for use in the future.
While the Government wanted to stimulate investing, its own tax revenues were falling steeply due to the same market collapse and subsequent recession – so allowing contributions to be deductible was a non-starter for Finance Minister Jim Flaherty. The only thing left was to allow the value of the investments to grow tax-free and let people withdraw money – original deposits and growth – tax-free.
So the workings are fairly simple – you deposit money when and as you wish and don’t get a tax-deduction. Once deposited, the money grows, based on the results of your investment choices, and you don’t pay tax on the growth. You can withdraw any portion or all of the funds in your TFSA at anytime without tax consequences. So far so good!
The follow-up question is not as easy however – in what financial products or instruments should you invest within the TFSA? From an economic perspective, the government wants to encourage more investment in capital markets – stocks and related securities – but are these the best investments for a TFSA? I suggest not – and here is why.
If I invest in our capital markets outside an RRSP, RESP or TFSA, I don’t pay tax on all of my capital growth and if there is a loss, I at least have the opportunity to claim all or part of the loss as a deduction against other capital gains. Not so if the investment is inside these products. Dealing strictly with TFSAs, any loss on my investments inside the TFSA is non-deductible at any time – on the other-hand, gains are never taxed. So, on the upside – things are great, on the downside, things are not so good.
As a general guideline, investments that would be taxed higher outside a TFSA should be used inside – such as interest income and dividend income – which tells me that GICs, Term Deposits, Bonds, Money Market Funds, Bond Funds and blue-chip Dividend Funds make more sense while higher-risk, capital-growth-oriented funds MAY be better held personally as non-registered investments.