By Colin S. Ritchie
If investing is the seductive and boisterous golden-haired child of the financial planning world, tax planning is the awkward, unassuming, bookish youth who often eats lunch in the cafeteria alone, but may one day rule the world. Although the former may get all the attention from day to day, the latter could actually hold the key to long-term success for many of us. If nothing else, combining good investment decisions with savvy tax planning can easily squeeze a lot more after-tax income out of many investment portfolios; as I like to say to my clients, it’s far less important to know what your investments earn than to know what you keep after the tax man has come and gone.
Learning how to maximize your family’s TFSAs is great example of this principle. Although making good investment choices is vital, learning how these accounts work, how to shelter as much money as possible, and how to best pass them on to your heirs is ultimately what can make the biggest difference. The next few pages will cover these issues. When you reach the spellbinding conclusion, I hope your family will enjoy the resulting tax savings for generations to come.
In a nutshell, Tax Free Savings Accounts are exactly as described. Any income or gains inside these accounts not only grows tax-free, but can be withdrawn tax-free as well. It means that you keep all of what you make — full stop.
In 2016, every Canadian 18 years of age and older earned the ability to shelter $5,500 in their TFSA (although most provinces won’t allow investors to actually open accounts until they are 19). Next year, we will all earn an additional $5,500, and so on, although the amounts we can contribute are indexed to inflation and rounded to the nearest $500. This means that the next increase in room will create $6,000 in new room each year, although it might take a few more years before inflation takes us to this level.
As with RRSPs, you can carry forward unused contribution room if you haven’t maximized your contributions. This means that someone who has never opened a TFSA and has been an adult since they were created in 2009 could shelter $46,500. Unlike RRSPs, however, you do not get a tax deduction for contributing to a TFSA. Furthermore, and also unlike RRSPs, you are allowed to replace money withdrawn from your TFSA in future tax years. In other words, if you withdrew $20,000 this December from your TFSA and had $30,000 in unused TFSA room, the following January, your contribution room would be the total of your previous $30,000 in unused room, the $20,000 you had withdrawn the year before, and the $5,500 in new room you earned just for making it through New Year’s Eve alive — all of which add up to $55,500.
Some financial institutions still seem to market these tax shelters as simply a glorified savings account that pay an interest rate that doesn’t keep up to inflation. Since the actual interest returns are so miniscule in the first place, the fact that they are tax-free is essentially irrelevant. It’s like using a tourniquet on a paper cut: a lot of effort for very little benefit. Don’t fall for this trap. If investing inside a TFSA, you have the same investment choices as when investing inside an RRSP or RRIF. This includes stocks, bonds, mutual funds, some options, private market investments, ETFs, segregated funds, principal-protected notes, and so on. Accordingly, unless you have no other form of savings or emergency fund, it makes sense to invest in assets that either produce a lot of income that would otherwise be taxed in your hands each year or to invest in those high-risk/high-reward stocks that don’t pay income now but might with luck double or triple in value someday soon.
On the income side, this generally means picking investments that pay substantial interest or income payments, e.g., bonds, Mortgage Investment Corporations or private market investments, all of which I see as undiscovered gems of the investment world for the right investors. For the same reason I dislike using TFSAs to invest in so-called “high interest” savings accounts offered through banks, I generally don’t like using TFSAs for GICS issued at today’s rates; although interest payments are generally the highest taxed form of income, currently GICs pay out so little that the actual tax savings from avoiding tax on this interest income is negligible.
There can be benefits to sheltering eligible dividends from Canadian companies in a TFSA as well, but, for those in lower tax brackets, this money may already be tax-free or even lead to a tax refund if owned in an open account. Accordingly, unless you are also expecting to earn significant capital gains on the investments, or if your portfolio consists exclusively of blue chip Canadian stocks that spit out dividends anyway, these stocks may not be a good first choice for your TFSA account. On the other hand, for Canadians in higher tax brackets or those worried about the OAS clawback, ignore most of what I just said. Although investments that pay income or interest may still provide you with more tax relief inside a TFSA than your blue chip babies, you can still save a lot of tax by sheltering even eligible dividends inside your TFSA — particularly if they also generate capital gains.
Continuing this line of thought, even though the tax bill on capital gains is generally 50% less than on interest-paying investments, if you’re shooting for the moon and hoping a stock will increase tenfold by Christmas, the benefits of sheltering the entire gain (despite the lower tax savings per dollar compared to interest income or even eligible dividends when in higher tax brackets) can easily make this a winning strategy. Although you save less tax per dollar, you’re earning so many more dollars as a result of a significant capital gain that you’re still saving more tax in total. As well, investing for gains inside your TFSA may ultimately mean increasing the size of your TFSA by more if it all works out, and this can mean even more savings in the future — such as when you sell that stock your brother-in-law mentioned during poker night at a handsome profit and reinvest the proceeds in high-income investments that do pay interest. The typical gain-focused TFSA investments include small cap stocks, private market equities (many of which pay a high income as well as offering potential gains), and even blue chip stocks with great potential if you don’t believe in riskier investments.
On the other hand, it’s important to know that if your brother-in-law gets it wrong and you later have to sell the sure thing he recommended at a loss you can’t apply that loss against gains in other taxable investments (as you could if you owned it in a non-registered account). Put another way, it means accepting a greater risk when investing for gains inside your TFSA versus investing for yield, since you don’t get the chance of reducing the impact of a bad investment by writing off the loss against future gains on other investments.
Advanced TFSA Strategies
The main complaint about TFSAs, especially when first introduced, is that they are too small in size to really make a significant financial difference in investors’ lives. While this may be true in the short-term — particularly when they were first introduced and each adult Canadian started with $5,000 in total contribution room — both investing and financial planning are long-term games. Years of initially small savings can ultimately lead to large benefits, particularly when the savings can snowball over time as the size of your TFSA grows, both as your investments (hopefully) bear fruit and you augment your profits by fresh contributions each year. This is where some of the advanced TFSA planning techniques come into play, as savvy TFSA planning now can multiply your savings later The following are some ways of potentially maximizing your family’s TFSA room, saving taxes and generally making the world a better place.
(a) Have the Wealthier Spouse Pay Twice
Although there are tax rules that attribute income and capital gains back into the taxable hands of the contributing spouse in most situations, this doesn’t apply when the guy or gal in the higher tax bracket funds his or her spouse’s TFSA. Accordingly, unless this means that the wealthier spouse won’t be left with enough money to make full RRSP or spousal RRSP contributions, having the wealthier spouse pay for both spouses’ TFSAs means freeing up more of the lower-income spouse’s money to invest at lower tax rates, or allowing the couple to transfer more of an existing portfolio taxed at higher rates in the wealthier spouse’s hands into tax-free heaven. You may wish to speak to a financial planner or tax expert if your situation is complicated, such as if you already have huge RRSPs or are debating RRSPs versus TFSAs in the first place (when you don’t have the cash flow or assets to contribute to both).
(b) Prioritize an Ill or Older Spouse’s TFSA
Although this may strike some of you (including the writer of this article) as rather morbid, I still believe that it’s worth discussing, since it can make a substantial difference to those left behind. While in most cases, it will make sense for both spouses to have TFSAs of about equal sizes, this isn’t true when there is a significant chance of one spouse dying first, such as when already battling illness or there is a significant age gap. In such circumstances, it makes sense to maximize the frailer spouse’s TFSA, even if it means borrowing money or withdrawing it from the other spouse’s TFSA. This is because one spouse can transfer what’s left in his or her TFSA tax-free to the other spouse at death. On the other hand, any unused TFSA room dies with the individual. Therefore, maximizing the frail spouse’s TFSA means that the survivor will continue to enjoy tax-sheltering on this money while still having his or her own TFSA — potentially allowing twice the sheltering than would otherwise be the case. Moreover, even if it was necessary to withdraw money from one spouse’s TFSA to top up the other’s, it’s important to remember that the amount pulled out to do so can be put back in during the next tax year. As a result, the only real downsides are the small withdrawal fee that often go along with taking money out of a TFSA, transaction costs, and having to wait until the next January until the money can be recontributed to the original TFSA (assuming the funds have become available).
(c) Make Your Spouse a Successor Holder Rather Than a Beneficiary
Name your spouse as a ‘successor holder’ rather than the beneficiary of your TFSA. This does two things: it means you don’t risk paying tax on some of the income the TFSA generates after the first spouse dies if it takes a while to wind up the TFSA, but, and probably more important, it makes life simpler for the surviving spouse. Although designating your spouse as the beneficiary will allow the survivor to get the balance of your account at your death tax-free and even add it to their own TFSA without using up any of his or her own contribution room, it generally means having to sell the assets in the deceased’s TFSA, convert them to cash, pay them to the survivor, and then contribute them to that survivor’s own TFSA. Using the successor holder designation cuts to the chase: it means the survivor can simply take over the deceased’s TFSA ‘as is’ without having to sell assets, pay commissions and fees, or fill out endless forms. This may be particularly useful if you own investments inside your TFSA that have deferred service charges that apply if liquidated prior to a certain date.
As an added bonus, you may still combine the inherited TFSA with your own TFSA if that makes sense. It simply means that you get to make the choice about when and where this might occur.
(d) Borrow Your Children, Parents and Other Relatives’ TFSA
In my view, TFSAs are like ice cream on a warm summer’s day on an empty stomach; second and third helpings are perfectly acceptable. In today’s financial reality, many younger Canadians simply don’t have the cash flow to maximize contributions to their own TFSAs. If they can’t use this tax shelter, then perhaps they would be willing to let you step into the breach. You could put your own money into a TFSA in their name(s) in order to shelter investments whose growth and income would otherwise be taxable to you. When they have the means to fund their own TFSAs, everyone will win. You could withdraw the balance from the original TFSA tax-free, benefiting from at least a few years’ of tax-free growth or income.
On the other hand, since anything withdrawn from a TFSA can be recontributed, it is hoped you will have increased their contribution room. In other words, if you fund your adult son’s TFSA to the tune of $46,500 tomorrow and he doesn’t need it for another five years — by which time the original investment soars in value to $70,000 — you will have increased his TFSA contribution room by $23,500 (to $70,000 from $46,500) when you withdraw the money, although he will need to wait until the next year to take advantage of this.
Moreover, in most situations, it is probably more realistic to expect that young adults won’t be able to take advantage of both their current and past contribution room all at once. Accordingly, rather than having to cash in the entire balance of the TFSA you funded, it might just mean that you no longer contribute fresh contributions to that TFSA, as the child needs only be able to shelter the $5,500 in new room each adult Canadian receives every January. In order to keep your financial affairs separate, it usually makes sense for the child to open a separate TFSA for their own contributions, with the TFSA you funded holding your contributions only. If the child’s financial situation improves in the future and they eventually want to take advantage of the contribution room you have borrowed from them, you can simply sell and withdraw as much money as they want to shelter the next year, after also taking into account the fresh room they will earn that January. For parents in far higher tax brackets, you might even keep your money in your child’s TFSAs but agree to pay the tax on the money they would have contributed to their TFSA each year. That way, the child still gets tax-free growth on their money but you can still come out ahead on your own tax return even after paying your children’s investment tax if you would have had to pay a bigger bill if the money was taxed in your own hands.
This strategy of borrowing your children’s TFSAs helps them in other ways as well. If they are ultimately the beneficiaries of your estate, the more money you save on taxes now will be more that they will inherit later. Even better, there would be no probate fees on this money at death, particularly if you set up the promissory note to be forgiven at that time, or forgive it prior to then.
Worried about creditor-protecting the money should your child have debt issues or get divorced? One option is to have the child sign a demand loan equal to the amount of your investment naming you as the beneficiary of the plan at death so that you receive the money tax-free at that time. Although this may not be an ironclad guarantee, it is often sufficient for most parents.
In B.C., it is even possible to take things one step further and have the child register you as an irrevocable beneficiary (“IR”). This means that you would essentially have control of the account, the beneficiary designation could not be changed without your permission, and the account would enjoy greater creditor protection. The child would not be able to change who gets the money on his death and the TFSA would not be part of that child’s estate (that is also true in this province for revocable beneficiary designations). In order to get the benefits of this extra protection, however, it is necessary that the company administering the TFSA receive a signed copy of the form naming you (and probably your spouse) as irrevocable beneficiaries. If exploring the use of irrevocable beneficiaries, however, do discuss this with your lawyer and financial planner as there can be some downsides, particularly if you are incapacitated. In such an instance, it could conceivably prevent anyone from managing or making withdrawals from the TFSA unless your financial institution allows someone acting under your Power of Attorney from releasing the IR designation. Although it is arguable that this is possible, it is not guaranteed and, at the very least, there would probably be a lot of administrative red tape along the way. Accordingly, although there are clear advantage to using and IR designation, there are some risks as well.
(e) Gift Contribution Money to Your Children
Not so worried about getting the money back to fund your own retirement? Consider simply gifting the children or grandchildren enough money to fund their own TFSAs. Essentially, this is a variation on the last strategy but is essentially an advance on your children’s eventual inheritance that may ultimately leave them better off than if you wanted until death to fund this gift, since the money will be growing tax-free in their TFSAs rather inside your non-registered or corporate accounts, where the tax bills may reduce profits from a flood to a trickle. Despite setting this up as a gift, you may still wish to use some of the creditor protection steps outlined in the previous subparagraph if you have worries about the child’s creditors or marriage.
Although TFSAs are only a recent addition to the Canadian financial planning scene, they are a welcome one. New contribution room is currently only $5,500 per year for now and the cumulative contribution limit is $46,500 for many adults who are currently considering becoming the proud owner of their first TFSA. Over time, (with help from the investment gods) this molehill may turn into a mountain, especially for those of us who are able to use some of the advanced planning techniques discussed in this article. Although $46,500 in tax sheltering room may not seem significant to some, when this is doubled to $93,000 when both spouses open accounts, perhaps this is enough to get your attention. If not, what about sheltering closer to $250,000 if this is also combined with 3 or 4 late 20 something adult children’s TFSA room, particularly if this room increases by perhaps a combined $30,000 per year?
Thus, although wise investment decisions will retain a key role in TFSA planning, knowing tax and financial planning strategies to supplement your investment savvy can be like getting a half dozen cookies for about the price of one– although that first cookie might be a tasty treat, getting that much more for about the same price can be immensely more satisfying. Although this side of the financial planning coin may not be as sexy as stock picking, combining the two can often create an unbeatable combination. If you or your investment advisor is the superhero, think of your tax and financial planner as the trusty sidekick that every superhero worth his salt wants by his side when the going gets tough.
Colin S. Ritchie BA.H, LL.B CFP CLU FMA and TEP is a fee-for service financial planner and a lawyer whose practice concentrates on wealth protection, tax, trusts and estate planning based in Vancouver, British Columbia. Previously, he worked as a director of Estate and Financial Planning for a major Canadian Insurance company and as a lawyer in private practice. Colin works with planning clients across Canada, including many clients who either handle their own investments or have existing investment advisors in order provide them with big picture planning. Colin is also personally the proud owner of many exempt market investments and is a referral partner of Klint Rodgers of Pinnacle Wealth Brokers. He can be reached at 778 233-8089 or firstname.lastname@example.org