Tax Free Savings Account Only News In Federal Budget
David Christianson, CFP, R.F.P., TEP
Most Canadians will pay less tax in 2008 than 2007, but not because of this week's federal budget. Most of the income tax changes and the decrease in the GST had been announced in past budgets and in the Finance Minister’s economic statement last fall. This budget does not change personal tax rates.
However, there are three things to make note of for personal tax situations. The first will allow people 65 years of age or older who are collecting the Guaranteed Income Supplement (GIS) to now earn $3,500 of employment income without affecting their GIS cheques. The current exemption is only $500, and GIS payments are reduced by 50 cents for every dollar earned above the exemption.
The budget proposes the Tax-Free Savings Account (TFSA), to start in 2009. This would allow Canadians to earn tax-free investment income on a small amount of capital. Unlike the RRSP, it will not provide any tax deduction for deposits, but future withdrawals will be tax free.
The ability to withdraw money at any time without restriction makes it a useful vehicle for an emergency fund or shorter term savings. In my mind, it simply replaces the old provision – eliminated in the 1980’s - that allowed $1,000 per year of interest to be earned tax-free.
The contribution limit is only $5,000 per year in 2009, increasing each year with the rate of inflation, in $500 increments. However, if a person contributes the maximum each year and reinvests the earnings, they could eventually be dealing with a significant amount of capital.
This would be a great thing for well-to-do parents and grandparents to set up for their kids as soon as they reach age 18. The real value will be once a substantial amount of money is built up in this new form of non-registered savings, which will take time.
Perhaps the best advantage with the TFSA will be for seniors and conservative investors who like to hold unregistered investments in vehicles like guaranteed investment certificates that pay interest. Since interest income is taxed at your full marginal tax rate (as opposed to dividends or capital gains that are earned on stocks and equity mutual funds), it stands to benefit most from this new tax-free status.
As well, investment income adds to a person’s "net" income, the figure used to calculate eligibility for income-tested programs like the Age Credit and clawback of OAS.
For example, a $5,000 GIC earning 4% will pay $200 a year interest. The taxes on that $200 will be between $54 and $92. If the taxpayer is in the OAS clawback zone (above $64,000 net income), or the Age Credit reduction zone (above $31,000), then another $27 to $30 is added to the tax cost.
In those situations, the potential saving is over $100 per year. If the taxpayer deposits $5,000 a year for a number of years and leaves the investment earnings in the TFSA as well, eventually the savings would add up to a measurable amount.
For taxpayers facing clawbacks of OAS or other tax credits, using the TFSA to shelter dividend income may be useful. The actual dividend you receive is "grossed-up" to an artificially large amount that is included in net income. This negatively affects these income-tested programs.
For income tax purposes, this grossed-up amount is offset by the dividend tax credit, so the actual income tax rate on dividends is very low. The real damage is caused to the income-tested tax credits and OAS.
However, people in the lowest tax bracket should continue to earn their dividends outside the TFSA, as the dividend tax credit actually pays them to earn dividends.
Capital gains can be deferred by careful investing, so these might not be the first choice to earn inside the TFSA. As well, capital losses realized within a TFSA cannot be claimed against outside capital gains, which can be a disadvantage.
In separate measures, Registered Education Savings Plans will now be allowed to remain open for 35 years instead of the current 25 years.
LIFs (Life Income Funds) that have come from transfers out of federally-regulated pension plans are going to be more flexible. The budget proposes that people age 55 or older will be able to wind up an account smaller than $22,450, convert 50% of a larger account into a non-locked RRIF, or unlock up to $22,450 in the event of hardship. (Most provinces already have similar measures for transfers out of provincially-regulated pensions.)
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This article originally appeared in the Winnipeg Free Press on Friday, February 29, 2008.
David Christianson is a fee-only financial planner and investment counsel with Wellington West Total Wealth Management Inc. His column, ‘Dollars & Sense’ appears Fridays in the Winnipeg Free Press.