Educate clients and employees about TFSAs
BY Vikram Barhat | February 5, 2013
The Canadian government recently announced that, starting 2013, it’s raising the annual contribution room for the Tax Free Savings Account (TFSA) to $5,500.
A great savings vehicle for low-income small business owners—and their employees—there’s plenty going for TFSAs. Canadians 18 years and older can contribute up to $5,000 annually to the account and can withdraw funds tax-free at any time.
Further, a TFSA allows you to invest in high-interest savings account, mutual funds, guaranteed investment certificates, listed securities, or other types of qualified investment products. The account holder doesn’t pay any tax on any investment income or capital gains.
Still, TFSAs remain vastly underutilized. A recent ING Direct report, for instance, showed more than half of Canadians (52%) don’t have a TFSA. Another 44% confess to having a vague understanding of how it works, while 19% say they were clueless about the product.
Owners & employees overlook TFSAs
They are relatively new and most people, including small business owners, are not clear as to when they are beneficial, especially compared to RRSPs, says Ed Rempel, financial planner and founder of Ed Rempel & Associates with dealer Armstrong & Quaile Associates.
“Group TFSAs are now available, so employers could give employees the option of contributing to a group TFSA,” he says. “However, payroll systems are setup to withhold less income tax for group contributions and tend to not be setup to allow for a TFSA contribution.”
Depending on individual situation, there can be significant tax savings over the years.
“TFSAs are very similar to RRSPs, except that there is no refund when you contribute, no tax on withdrawals, and the contribution limit is only $5,000 per year [$5,500 from 2013],” says Rempel. “Any amount invested grows tax-free until withdrawal.”
The most common error is to use TFSA as a savings account. Rempel says “the benefits are much higher if you have your retirement investments grow tax-free compared to just avoiding tax on a savings account at very low interest.”
To make an educated decision about whether to use TFSA or RRSP, business owners need to consider their tax bracket now versus in retirement.
Jamie Golombek, managing director of tax and estate planning, CIBC Private Wealth Management says given that the product is only four years old, its penetration is actually not that bad.
“But I think still there’s misperception out there, may be because of its name,” he says. “[People think] it’s not meant for any other thing but savings; may be [it should have been] called tax-free investment account.”
RRSP contributions are tax deductible and help lower the annual tax amount, known as the RRSP refund. “Mesmerized by the refund,” investors tend to ignore TFSAs, says Rempel.
“The prime reason most Canadians choose RRSPs is for the refund,” he says. “RRSPs are tax deferred, though, since you have to pay tax on withdrawal.”
Alternative to RRSPs
In fact, a TFSA can be a great alternative to an RRSP or a RRIF for those in the lower tax rungs, says Golombek.
Read: Canadians eying TFSAs
“If you are in a low income bracket now and [will likely] only go up, you may be better off contributing to TFSA right now when you have a low rate,” he says. “Pay your tax upfront at whatever your rate is, put the net amount in to TFSA; the money comes out completely tax-free, perhaps when you’re in a higher bracket.”
To be specific, anyone earning less than $43,000 today should probably contribute the maximum to their TFSA before contributing anything at all to RRSP.
“TFSA is far better, since [investors] may be taxed at 50% to 75% on their RRSP withdrawals when they retire,” says Rempel. “This would include many employees, which is why group TFSAs should be used in any company where quite a few employees earn less than $43,000 per year.”
Setting up a TFSA is just as easy as setting up an RRSP. “There is generally no cost for TFSAs with one investment firm,” says Rempel. “A self-directed TFSA generally has a much lower annual administration fee than a self-directed RRSP.”