There is much debate about the future of Tax-Free Savings Accounts and how they are used. Some people suggest TSFAs are so popular that they are costing a debt-ridden Federal government a fortune in lost tax revenue and should be scrapped. Others feel too many people have been shovelling their money into Exchange Traded Funds outside of their TFSAs, not taking full advantage of the latter. And still others want the government to let people hold annuities in TFSAs, to bolster retirement income during an era when few companies offer Defined Benefit pension plans anymore.
After the global financial crisis, the government launched TSFAs in 2009 to encourage people to invest in stocks and funds to aid an economic recovery. TFSAs work opposite to Registered Retirement Savings Plans, and the two should be used in tandem. With RRSPs, you get a tax break up front on contributions, but then pay tax on the withdrawal of contributions and earnings at your marginal tax rate. With TFSAs, you get no tax break on contributions, but you pay no tax on withdrawal of contributions plus earnings. The strategy has been to contribute to TFSAs while in a low tax bracket and make withdrawals while in a high bracket, the opposite of contributing and withdrawing with RRSPs.
People are advised to contribute to TFSAs while starting their careers in their 20s and early 30s, then move money into RRSPs during their peak earning years, and contribute to TFSAs again if earned income falls while approaching retirement. Hold investments that you are taxed most on, namely those paying interest, in TFSAs. Hold investments that are least-taxed, either those paying dividends or capital gains depending on your tax bracket, in RRSPs. Another ploy is to hold stocks or funds you expect to make huge gains inside your TFSA, avoiding tax on large profits.
TFSAs started out with a maximum $5,000 annual contribution limit, increased to $5,500 in 2013 and 2014 due to inflation, hiked to $10,000 by the Conservative government in 2015, then reduced back to the current $5,500 by the new Liberal government in 2016. A person who was 18 years or older in 2009 and has never made a contribution has $57,500 in room as of 2018.
There have been a few TFSA hiccups. Some people over contributed $100,000 for a couple of weeks or months, making huge gains that dwarfed the penalty of one per cent per month on the over contribution. The government changed rules so that if you make a withdrawal, you don’t get that contribution room back until Jan. 1 of the following year. In 2016 the government ruled that people making frequent trades in their TFSAs were conducting a business, and therefore their profits were taxable. And people are now penalized on contributions made while they are a non-resident of Canada.
Canadians now contribute $26 billion a year to TFSAs, and as of 2016 nearly 17 million Canadians held $194 billion in TFSA accounts. Due to the lost tax revenue, there have been suggestions governments might scrap TFSAs or declare withdrawals as taxable income, which could cause many seniors to have their Old Age Security benefits clawed back.
It has also been noted that many people use TFSAs for additional retirement income. As such, it has been argued that annuities should be allowed to be held inside TFSAs. Annuities are insurance products in which you invest a lump sum up front and are guaranteed either fixed or variable payments starting at some future date. Annuities have been out of favour while interest rates have been at historic lows because you have to contribute a huge amount up front to enjoy sizable payments down the line. The problem is annuities have to be taken out later in life, whereas TFSAs currently offer liquidity allowing holdings to be withdrawn anytime without penalty.
The compromise between scrapping TFSAs or increasing contribution limits would be to keep maintain TFSAs and keep the limit as is. And with the Bank of Canada recently raising interest rates and signalling future increases, annuities are becoming appealing and allowing them inside TFSAs should be studied.
Ray Turchansky is a tax and personal finance consultant.