Clearing up confusion around Tax Free Savings Accounts

By Donna Glasgow | February 21 2012 06:46PM

A number of recent surveys have underlined that Canadians are unsure what Tax Free Savings Accounts are exactly and what can be done with them.
Jamie Golombek, the Toronto-based managing director of tax and estate planning with CIBC Private Wealth Management, says he sees two main areas of confusion. One problem is fundamental and the other is technical.

“Fundamentally we still find that many Canadians don’t realize that TFSAs are more than just a savings account,” he explains.

TFSAs can hold nearly anything that an RRSP can, such as mutual funds, GICs, stocks and individual bonds, yet many people still think of a TFSA as a pure savings vehicle.

“They deposit it and get a relatively low rate of return, whereas in fact if you used it as part of a retirement plan, then TFSAs could be very, very effective if invested for the long-term.”
Mr. Golombek believes the reason for this lack of knowledge has a lot to do with the name Tax Free Savings Account and that “Tax Free Investment Account” would have been a better choice.

Advisors’ role
But since the TFSA name is ingrained in legislation, Mr. Golombek doubts it will ever be changed. So, education is the solution to helping Canadians better understand this investment vehicle and advisors play a key role in this process. As people begin to understand the investing flexibility offered by TFSAs, they will start to use them more effectively, Mr. Golombek believes.

“Let’s be honest, the main feature of TFSAs is that they are tax free. If you are using them as a savings account and you’re getting 1.2% interest in our low rate environment, you haven’t saved a lot of tax…”

Mr. Golombek says he advises using TFSAs in conjunction with a long-term savings plan. He generally recommends putting the investments that are expected to have the highest possible returns inside of the TFSA. “That’s really your best benefit. So I think advisors need to educate clients in that regard.”

The most effective way to get individuals to better use TFSAs is to include them as part of a financial plan, says Mr. Golombek.

“Every single client meeting that I have I ask, ‘Have you set up and maximized TFSAs for yourself, for your spouse or partner and for all your children who are 18 (or over)? That’s the first question I ask as part of a planning meeting. And, everyone should ask that question.”

He adds that his clients – who come to him for a financial plan and advice – are generally more sophisticated than the average investor and are putting equities into their TFSAs.

“But I think the problem is that many people don’t deal with an advisor…and I think people really need to get the advice to do this properly.”

For Mr. Golombek, the second major area of confusion is a technical point. Many TFSA holders have gotten themselves into trouble when transferring money from one TFSA account to another and were assessed over-contribution penalties as a result. Advisors need to educate clients on the rules regarding transfers to avoid such penalties, Mr. Golombeks says.

A person can transfer money from one TFSA account to another either within the same financial institution or between various financial institutions or various advisors. However, this has to be done via a direct transfer, he explains. Taking money out of one branch and depositing it into another account the next day would be considered a withdrawal. The rule is that withdrawn money can’t be redeposited until the following calendar year, unless the person had enough unused TFSA contribution room to make such a deposit without incurring a penalty.

“So if you want to move money from Advisor A to Advisor B in different TFSAs, you don’t simply take the money out of A and put it into B. That would be considered to be an over-contribution if you’ve fully maxed out your contribution room. What you would do is tell Institution A that you want to do a direct transfer to Institution B. If it is sent via direct transfer it is coded differently and should not result in an over-contribution penalty,” Mr. Golombek explains.

Canadians ages 18 and over can invest $5000 annually in a TFSA. For those who have never made a contribution, their maximum TFSA contribution room would be $20,000 as of January 2012.

Vancouver-based Anthony Windeyer, business, insurance and estate planning specialist with Coast Capital Insurance Services Ltd and a certified financial planner, says that he goes over the contribution rules carefully with clients so that they don’t incur the penalty which is 1% per month levied on the over-contributed amount.

In particular, he warns that if a client is using his TFSA as an emergency fund and taps into it during the year, then he must not try to redeposit the money that same year.

“They have to wait until the following year…otherwise they can incur that penalty.” This applies to clients who have maxed out their TFSA contributions and do not have the room to redeposit the funds withdrawn.

Meanwhile, David Phipps, a senior financial advisor with Assante Capital Management in Ottawa, says that a common misconception he runs into is that TFSAs are always a good idea when often they are not.

“In my opinion, Tax Free Savings Accounts are oversold, not undersold,” says Mr. Phipps. For example, he often sees people who have money sitting in a TFSA who also owe money. They may be paying out perhaps interest of 4.5% in a line of credit. He asks these clients where they can get a guaranteed rate of return of 4.5% in their TFSA? The answer is they can’t. “There is no guaranteed investment that offers a yield equal to the cost of borrowing because there is always a spread. That is how banks make their money.”

So who needs a tax free savings account? Mr. Phipps says it is the person who has paid off all their debt and maxed out their RRSP. “There aren’t that many of those.”

Low-income Canadians
Mr. Phipps underlines that he would adjust this advice in the case of a low-income person. “For poor people, the Tax Free Savings Account should probably be used before the RRSP. Having an RRSP could impact their Guaranteed Income Supplement in retirement, he notes.

Mr. Windeyer also underlines that TFSAs are not for everyone. “When we sit down with a client the first thing to do is a fact find and figure out exactly what their situation is and discuss what their goals are, identify what their cash flow is and then produce a financial plan for them. From there, we discuss the various tax shelters they should be considering. If a TFSA is a good fit for them, we would set one up and start funding it.”

He also says that TFSAs are often the best option for lower income Canadians since TFSAs do not affect GIS qualification.

“A tax free savings account is a fantastic solution for someone with low income, as well as for someone with extremely high income. Then of course there are the people in between where it could be applicable or not, depending on the circumstance,” says Mr. Windeyer.