Tax-free investing gets serious

March 25, 2012 • Financial Planning

When the Tax-Free Savings Account (TFSA) was launched, the features of tax-free growth and tax-free withdrawals drew a lot attention. The $5,000 contribution limit, however, didn’t seem like much.

But as of January, 2012, you can have $20,000 invested, or $40,000 for a couple when you count each spouse’s TFSA. Now the TFSA carries weight.

Here are some of the ways a TFSA can play an important role in your overall investment program.

Income splitting

The government has quite a few rules in place to prevent income-splitting, including attribution rules that require you to pay tax on investment income generated by funds you give to your spouse. But no such rules apply to TFSAs.

You can give money to your lower-income spouse or adult child that he or she can contribute to a TFSA. No income your spouse or child earns in their TFSA is attributed back to you.

Grandparents can also give funds to grandchildren over the age of 18 to contribute to a TFSA.

Retirement planning

Your TFSA can be a valuable complement to your RRSP and non-registered retirement program. With annual contributions of $5,000, indexed to inflation, plus investment growth, your potential earnings by the time you retire are substantial.

In addition, withdrawals are tax-free. That means that any withdrawals you make will not attract income tax or reduce your eligibility for income-linked programs like Old Age Security.

There’s another benefit, too. Once you roll over your RRSP to a RRIF, you are required to withdraw a certain amount every year. If you don’t need it to cover your living expenses, you can contribute this money into your TFSA and continue to benefit from tax-free growth.

Education savings

A lot of parents take advantage of a Registered Education Savings Plan (RESP) to save for their kids’ post-secondary education. A potential drawback, however, is the lack of flexibility. If your child chooses not to attend post-secondary education, you my have to take some or all of the accumulated plan earnings into your own taxable income. Even worse, it’s taxed at your regular rate plus an additional 20%.

You’re allowed to transfer up to $50,000 of plan earnings to your Registered Retirement Savings Plan (RRSP), but only if you have contribution room available. Any payments made into the plan from the Canada Education Savings Grant (CESG) program must be repaid to the government.

Using a TFSA for education savings, whether instead of or in addition to an RESP offers tax-free growth along with much more flexibility. You and your spouse can withdraw funds from your TFSAs to pay for your child’s schooling. The withdrawals are tax-free and the withdrawn amounts are added to your TFSA contribution room the following calendar year. You can also give a child who is 18 or older the funds to contribute to his or her own TFSA.

Estate planning

You may not have thought of TFSAs as a way to pass on wealth to the next generation. But consider this scenario. A couple each contributes the maximum to their own TFSAs and the TFSA of an adult child – $15,000 annually. In just 10 years, based on a 5% annual return, they will have accumulated over $198,000 for their child — all of which can be paid out tax-free upon their death.

Please talk to us about your plans for your TFSA. We can help you choose appropriate investments and coordinate your TFSA, RRSP, RESP and non-registered accounts for maximum effectiveness.

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