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  • 1. Tax Free Savings Accounts: A Young Investors Perspective Max Miller
  • 2. Introduction: TFSAs (Tax Free Savings Accounts) are an exciting opportunity to save within a number of different investment vehicles, and grow money tax free. TFSAs can be used to save for short term goals, such as a vacation - or long term goals, such as funding an education or retirement. In short, TFSAs offer attractive financial planning opportunities that allow easily accessible savings to grow faster than in a regular investment account. Although TFSAs were first introduced by Canadian Finance Minister, Jim Flaherty, in his 2008 budget – most Canadians know little about them. In a recent survey by the Bank of Montreal, almost 40% of the respondents had no idea as to what investments were deemed eligible as a TFSA investment option (Duffin&Bensadoun, 2010). The means of this paper is to bring about a better understanding of TFSAs, in order to maximize your future investment portfolio. Conceptually, TFSAs are simple. You deposit money into an account and later withdraw it tax free to use as you desire. However, TFSAs are much more complex than they appear, and must be fully understood in order to maximize their benefits. This paper addresses a wide variety of topics and provides up-to-date answers to all your TFSA questions. Tax Free Savings Accounts are a great way to build personal wealth when used properly. I hope this paper will help you achieve that, and bring you closer to saving towards your financial goals of the future. History of TFSA’s: Although TFSAs were first formally introduced to the general public during Mr. Flaherty’s Budget Speech in 2008, its origins can be traced back to the early 2000s. The idea of a tax free savings vehicle was first brought into play by the C.D Howe institute, a non-partisan think-tank based in Toronto. It began advocating what it called Tax Prepaid Savings Plans (TPSPs) as early as February 2001, in a study titled “A New Option for Retirement Savings: Tax Prepaid Savings Plans”(Pape, 2010). The idea behind the creation of this study stemmed from the fact that Canadians didn’t have the right incentives to save for the future and were being punished for investing with their hard earned money. TFSAs first reached parliament when Mr. Flaherty’s predecessors, Liberal Finance Ministers John Manley and Ralph Goodale, both raised the idea in their 2003 and 2004 budgets. In the 2003 budget, the government stated it would examine the impacts of TFSAs, and consult whether they might be a useful and appropriate additional savings vehicle for Canadians. Finally on February 26th 2008, Mr. Flaherty stood up to give his budget speech in the House of Commonsand announced Tax Free Savings Accounts,declaring“Canadians will now have a powerful new incentive to save money, tax-free” (Pape, 2010).
  • 3. Basic Rules: In order to maximize the benefits received from TFSAs, you must have a strong understanding of the basic rules and regulations. Before we get deeper into the positives, I will review the key points involved with TFSAs. Eligibility In order to order to open a TFSA, you must be a resident of Canada, with a valid Social Insurance Number Age Limit Individuals must be the age of majority within their province to open a TFSA account. In Ontario this means individuals aged 18 and older. In jurisdictions such as British Columbia, Nova Scotia and New Brunswick, the age of majority is 19. Also, there is no maximum age for holding and contributing to a TFSA. Contribution Limit The initial annual contribution limit was set at $5000 per person. In subsequent years, the limit will be indexed to inflation and increased by an amount rounded to the nearest $500 (BMO Financial Group, 2010). All unused contributions from previous years can be carried forward indefinitely and withdrawals made in one year are to be added to the cumulative contribution room for the following year. This means that contribution room begins to accumulate the year you turn the age of majority, regardless of if the account has been opened. TFSA contribution limit formula = Unused contribution room from previous year + annual contribution limit ($5000 )- current year contributions + previous year’s withdrawals 2 BMO Financial Group.Tax-Free Savings Account (TFSA) Strategy Guide.BMO Financial Group, 2008. Print. Over Contributions Individuals, who unintentionally over contribute to a TFSA, will be subject to a tax equal to 1% of the highest excess amount in the month, for each month the account is over the contribution limit. If it is determined that the over contributions have been made intentionally, the individual will be taxed at a rate of 100%. (Pape, 2010) Number of Plans There is no limit on the number of TFSAs you can open. However, no matter how many plans are opened, contribution room remains the same. You should limit yourself to one plan for ease of administration, and to avoid over contribution fees. Withdrawals Money can be taken out of a TFSA at any time, and is received 100% tax free. As mentioned earlier, any amount you withdraw is added back to your contribution limit for the next year. However, you cannot re-contribute withdrawn amounts within the same calendar year, without being hit by an over contribution charge. Withdrawals are not reported on the account holder’s income tax return and therefore don’t affect federal income tested government benefits or tax credits(BMO Financial Group, 2010). Investments TFSAs are highly flexible when it comes to the investments you can choose. They generally have the same list of investments as for RRSPs and RESPs. Cash, guaranteed investment certificates (GICs), mutual funds, publicly traded securities, bonds, commodities and certain shares of small business corporations are all forms of viable investments. Non-eligible investments can be quite costly. In October 2009, the Department of Finance announced amendments to
  • 4. the Income Tax Act that will impose a 100 percent tax on any income attributed to non-qualified investments held in TFSAs (Pape, 2010). Investment Tax Strategies: In order to maximize the tax efficiency of your TFSA, it is essential you choose the right securities for the plan. In order to do so, you must obtain knowledge of how various securities are taxed within Canada. Interest.100% of interest income is taxable. Capital Gains.50% of capital gains are included in taxable income. Dividends.More than 100% of dividends are taxable, but are eligible for a dividend tax credit which dramatically cuts the rate you will pay. (TaxTips.ca, 2010) The taxation of securities is dependent on the income tax rates in Canada. This includes both Federal and Provincial tax rates. In Ontario the income tax rates for 2010 are as follows. (Canada Revenue Agency, 2010) Now that a basic understanding of tax rates in Canada has been determined, let’s look at some basic tax- saving strategies. Capital Gains Strategy TFSAs have the long term effect of making all capital gains tax free. Instead of paying tax on half of your profits, you get to keep the whole amount. Focusing your TFSA solely on capital gains has the potential of producing large profits quickly, however there is increased risk involved.If a capital loss occurs, all contribution room lost is forgone forever. However, It is not unrealistic that with sound advice, a solid understanding of markets and some research, high quality stocks can be obtained – which can double or even triple in value. This strategy allows you to build up your TFSA much faster, since any withdrawals from a plan are added back to your contribution limit in future years. Dividend Strategy Although the Dividend Tax Credit decrease the amount of taxes paid on dividends, by placing dividend paying stocks into your TFSA you pay no tax at all. This allows you for a constant secure flow of income, with the potential of a capital gain.
  • 5. Interest Strategy This strategy is for people that prefer safety and have little temperament to accept stock market risk. If you have a long time horizon, the interest earned from GICs and bonds can grow significantly through compounding interest. The key is to aim for the highest possible return, consistent with safety. Magic of Compounding:1 The power of compounding is one of the most important investment concepts for young adults to comprehend. It’s a simple but powerful way to make money, provided you have self-discipline and time. The ability to properly understand and apply this concept has the potential to earn you more return than any investment tip you will ever receive. In simple terms, compound income simply means money earing money. It is calculated as follows: t(1+i)n t = initial investment i=rate of investment n=compounding periods In reality compounding faces many obstacles, including the government sticking their hands into profits through taxes. Situations like these have held Canadians back, leaving them with no way to fully benefit from the power of compounding. TFSAs have the ability to change everything, allowing access to an investment vehicle that will permit you to obtain the full potential of compound income. Simple Returns vs. Compound Returns In order to properly understand the power of compounding, we must look at some basic calculations. For the following examples, we will assume a very a basic economy with no taxes or transaction costs and reinvestments are at the prevailing rates. Simple Returns Simple returns are the profits received from any investment in interest, dividend or capital. With simple returns, the money earned on the investment isn’t re-invested, but instead is quickly spent in celebration. For example, you purchase a $1,000 bond at face value with a 10% interest rate paid annually. Each year, you receive $100 in income, for a simple return of 10%. When the money is received, it is time to celebrate, and all your investment income is spent. This pattern continues for the life of the bond, and at the end of 10 years you are left with a $1,000 return on investment, created from the 10 payments of $100 per year. 1 Calculations for this section from http://personalwm.com/2009/12/10/compound-return-investment-lessons/
  • 6. Compound Returns Compound returns are very similar to simple returns, except the income received from the investment is not spent. Instead, the money gained is re-invested into the same bond fund as the original investment. For example, you purchase a bond fund that will yield 10% annually for $1,000. At the end of year one you will have earned $100 income, which is the same amount received in the simple returns example. However, the big difference is that this time the income earned isn’t spent, and is automatically re- invested in additional units of the fund. Now you have that $100 of earned income, which will start to earn income itself for the remaining 9 years of the investment. That is the key to the power of compounding: each penny earned on your investment will begin to generate its own future returns. At the end of year two, your original investment of $1,000 will have earned another $100, plus year 1 income of $100 will have returned an additional $10. This pattern will continue over the life of the investment and after 10 years, your investment has earned you $1,594. Compare this to the final amount in the simple returns example of $1,000, and you have generated an extra 59% return over the 10 years. As you can see the investor did significantly better when using compound returns. Compound Return Investment Lessons Now let’s take a quick look at some basic compound investment lessons. These will hopefully greatly enhance your investment returns. For these lessons, we will use the same basic data as the examples above. You invest $1000 in a bond fund that earns a 10% rate of return, compounded annually. Start Young Time plays a key role in the value of compound income. In our example, after 10 years, the initial investment grew to $2,594. However, if you leave that money alone for 50 years, your lone investment of $1000 will grow to $117,391. Compare that to the $5000 earned after 50 years (50 years x $100 interest/year) from a simple return. The difference illustrates how powerful compounding can be over time. The Extra Point of Return Following the same example as above, the rate of return has a large influence on performance of compounding. Had you found an extra percent of return, over 10 years you end up at $2839, an improvement of 9.5%. Looking over 50 years, you get $184,565, a change of 57%. The Power of Tax Free Costs such as taxes and transaction fees all reduce your overall return, limiting the ability to compound income. This means that less money will be re-invested, thus significantly affecting the power of compounding over time. To keep it simple, let’s assume that you pay a 30% tax rate on your earned income. This means that for each $100 of income which is normally earned, you only receive $70 to reinvest. Staying consistent with the examples above, over 10 years your money would grow to $1,967. This is not a huge loss, however, when looking at a span of 50 years the amount of $117,391 earned tax
  • 7. free, is reduced to $29,457 after tax. This enormous difference in income earned shows the power of which a combination of tax free savings, time and compound income can create. TFSA vs. Canadian Savings Vehicles: TFSA vs. RRSP (Registered Retirement Savings Plan) TFSAs and RRSPs are two very different types of vehicles from both a tax and savings perspective, with the biggest difference being the timing of taxes. TFSAs are tax shelters, whereas RRSPs are tax deferrals. TFSAs are what are known as TEE plans (Tax, Exempt, Exempt), this means the money going into the plan has already been taxed, but both earnings and withdrawals are tax-free. RRSPs are known as EET plans (Exempt, Exempt, Taxed), wherein contributions and investment income are tax free, however all withdrawals are taxed at the marginal rate (Pape, 2010). This means that higher income people who expect their tax rate to be lower in the future should top off their RRSPs before investing in a TFSA. On the other hand, people who expect their tax rate to be higher in the future should start contributing to their TFSA immediately. This means that young adults with little to no earned income can benefit from waiting to use their RRSP contribution room until they have a higher marginal tax rate. Also, at a young age you can begin to build your TFSA and when your marginal tax rate grows, make the withdrawals and begin to contribute to your RRSP. By doing so, down the road you will still have the ability to re-use the TFSA contribution room created by the withdrawals. As well, another advantage of TFSAs is that there is no time limit for contributions, unlike RRSPS which have to close after age 71. TFSA vs. RESP (Registered Education Savings Plan) Although there are many similarities between TFSAs and RESPs, the key differences involve the strings and conditions attached to RESPs. Firstof all, investment income earned within each plan is taxed when it comes out, however they will be taxed as income received by your beneficiary. These plans are specifically intended for educations saving, a factor which makes RESP savings risky, if your beneficiary decides not to pursue post-secondary educationan extremely high tax penalty can be placed on the contributor (Pape, 2010).The best strategy for students would be to invest money from part time jobs/summer employment in a TFSA and pay no tax on the investment earnings, as well as having ease of withdrawal. TFSA vs. Non-Registered Account TFSAs are most appealing as a replacement for non-registered accounts, since taxes can have a substantial impact on your investment earnings. Although the money in a TFSA is taxed when it is put into the account and capital losses are not tax deductible, TFSAs makes sense for just about every investment goal when compared to an individual account. For a young investor, TFSAs allow for a good opportunity to explore the complex world of investing. Currently with the growing contribution room, tax-free growth, and power of compounding, there is no longer a need for regular investment accounts for today’s young investor. Problems and Limitations: Confusion over TFSAs- A major problem with TFSAs, which have caused a large amount of confusion, is the choice of its name. The inclusion of the word “savings” has misled many people to believe that the accounts could only be used for savings-type deposits, rather than a place for tax-free investments to grow.In a recent BMO survey, 36% of respondents said they have a TFSA, but almost 40% remain unaware of viable TFSA investment options. Less than half of respondents, around 45%, considered cash to be an eligible investment option, while only 20% knew that mutual funds are eligible within TFSAs
  • 8. (Duffin&Bensadoun, 2010). A much better choice of name, which would have fixed many of the current issues in peoples understanding, would havebeen “Tax Free Investment Accounts”. This would have avoided giving the impression that they were extremely limited in scope. Confusing Contribution Room Another major problem with TFSAs has been consumer’s treatment of contribution room. In early 2010, more than 70,000 people faced potential tax bills as a result of over-contributions to their TFSA, mostly due to misunderstanding of the rules (Stewart, 2010). These penalties from over-contribution can be far more than any interest earned. Under guidelines, you can contribute up to $5000 per year and withdraw the money anytime. This seems simple, but the issues begin when people try putting money back into their TFSA. To do so without penalty, you must wait until the next calendar year, where all withdrawals are added back onto your contribution room. Luckily, many of the fines placed on Canadians, have been waived as a result of CRA’s tax fairness provisions. Government Revenue Forgone – TFSAs in the Future The impact on the federal treasury may be insignificant in the first few years, but over time it will grow exponentially. It was estimated that at the end of 2009-10 fiscal year, around $50 million tax revenue was forgone. By 2012-13, the estimated tax savings from TFSAs will be around $385 million. Eventually, twenty years into the program, Ottawa estimates the program will cost $3 billion annually (Pape, 2010). As time passes and the level of taxes forgone increase, therefore the government will most likely change the rules regarding TFSAs in the future. Therefore one must take advantage of TFSAs before the benefits become limited. TFSA as a Primary Income Creator – Day Traders TFSAs can become a large problem when they are used as a primary income producer. Day traders can easily take advantage of TFSAs because every cent that is made within a TFSA doesn’t have to be declared. This means that day traders can use TFSAs as their primary source of income, and pay no tax on the majority of revenue earned. Once they grow their account large enough, skilled day traders can sit back and enjoy a tax free lifestyle trading within their TFSA. Conclusion: Hopefully this paper has made you come to the realization that TFSAs can greatly help you reach your financial goals. With a combination of youth, discipline and investment insight, TFSAs have the ability to make your investment dreams come to reality. They are an exciting opportunity to save within a number of different investment vehicles, and grow money tax free. With the creation of TFSAs, Canadians now have a powerful new incentive to save money. If you haven’t already opened a plan it’s time to start garnering the benefits of this unique program.
  • 9. How to Open a TFSA Bank of Montreal Area of Operation: National Website: www.bmo.com Contact Phone Number: 1-877-225-5266 Options Available: Eight Option 1: BMO Tax-Free Savings Account - Type: Savings Account - Minimum Investment: $50 - Fees: None Option 2: BMO Cashable RateRiser GIC - Type: Cashable Guaranteed Investment Certificate - Minimum Investment: $1000 - Fees: None Option 3: BMO Redeemable Short-Term Investment Certificate - Type: Cashable Guaranteed Investment Certificate - Minimum Investment: $1000 - Fees: None Option 4: BMO RateRiserPlus GIC - Type: Locked-in Guaranteed Investment Certificate - Minimum Investment: $1000 or $5000 if monthly interest payment option is chosen - Fees: None Option 5: BMO Short-Term Investment Certificate - Type: Locked-in Guaranteed Investment Certificate - Minimum Investment: $1000 - Fees: None Option 6: BMO Guaranteed Investment Certificate (GIC) - Type: Locked-in Guaranteed Investment Certificate - Minimum Investment: $1000 or $5000 if monthly interest payment option is chosen - Fees: None Option 7: BMO RateRiser Max (GIC) - Type: Locked-in Guaranteed Investment Certificate - Minimum Investment: $1000 - Fees: None Option 8: BMO Mutual Funds - Type: Mutual Funds - Minimum Investment: Minimum Investments are Dependent on the Fund being Purchased - Fees: No Administration or Withdrawal Fees for a TFSA, any Applicable Fees for the Underlying Investments will Apply. BMO InvestorLine Area of Operation: National Website: www.bmoinvestorline.com Contact Phone Number: 1-888-776-6886 Options Available: One Option 1: BMO InvestorLine TFSA - Type: Self-Directed - Minimum Investment: $1000 - Fees: Annual Administration Fee of $50 unless total assets exceed $100,000 BMO Nesbitt Burns Area of Operation: National Website: www.bmonesbittburns.com Contact Phone Number: 1-416-359-4000 Options Available: One Option 1: BMO Nesbitt Burns TFSA Type: Self-Directed Minimum Investment: Not Available – Consult Investment Advisor Fees: Annual Administration Fee of $50
  • 10. 4 Pape, Gordon.The Ultimate TFSA Guide: Strategies for Building a Tax-free Fortune. Toronto: Penguin Canada, 2010. pg 128. Works Cited BMO Financial Group.Tax-Free Savings Account (TFSA) Strategy Guide.BMO Financial Group, 2008. Print. Duffin, Matthew, and Sarah Bensadoun. "REPEAT-BMO Survey: TFSA Program Turns Two-Canadians Quick to Adopt but Lack Clarity on How to Maximize Their Investment." Marketwire: Press Release Distribution, Newswire, Public Relations, Investor Relations, Breaking News, Media Monitoring. 9 Nov. 2010. Web. 6 Dec. 2010. <http://www.marketwire.com/press- release/REPEAT-BMO-Survey-TFSA-Program-Turns-Two-Canadians-Quick-Adopt-but-Lack- Clarity-on-How-TSX-BMO-1349703.htm>. JMW."Compound Return Investment Lessons."Personal Wealth Management. 10 Dec. 2010. Web. 14 Dec. 2010. <http://personalwm.com/2009/12/10/compound-return-investment-lessons/>. JMW."The Power of Compounding."Personal Wealth Management. 09 Dec. 2009. Web. 13 Dec. 2010. <http://personalwm.com/2009/12/09/the-power-of-compounding/>. Pape, Gordon. "50Plus : Money : TFSAs vs. RRSPs." 50Plus.com. 16 Nov. 2010. Web. 08 Jan. 2011. <http://www.50plus.com/money/tfsas-vs-rrsps/210/>. Pape, Gordon. The Ultimate TFSA Guide: Strategies for Building a Tax-free Fortune. Toronto: Penguin Canada, 2010. Print. Stewart, Jennifer. "TFSA Puzzle: Why Don’t More People Have One? - Moneyville.ca."Moneyville - Welcome to Financial Possibility. 06 Dec. 2010. Web. 14 Dec. 2010. <http://www.moneyville.ca/article/899669>.
  • 11. "TaxTips.ca - Tax Treatment of Income from Shares of Corporations."TaxTips.ca - Canadian Tax and Financial Information. 19 Sept. 2010. Web. 12 Dec. 2010. <http://www.taxtips.ca/personaltax/investing/taxtreatment/shares.htm>. "What Are the Income Tax Rates in Canada?" Canada Revenue Agency Web Site | Site Web De L'Agence Du Revenu Du Canada. 23 Aug. 2010. Web. 12 Dec. 2010. <http://www.cra- arc.gc.ca/tx/ndvdls/fq/txrts-eng.html>.