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The Loophole with TFSA's

By Jeffrey Sindall, October 1, 2015


The Tax Free Savings Account (TFSA) allows Canadian residents over age 18 the opportunity to contribute after-tax income or savings (money on which they have already paid tax) to an account which can grow tax-sheltered and from which all withdrawals are not taxable as income. This is fundamentally a third type of investment plan which is taxed differently from 1) the original "Open" investment plan, and 2) the government's previously created "Registered Plans" (such as RRSP's or pensions). The tax treatment of TFSA's is most like that of a principal residence in Canada; a principal residence is purchased or improved with after-tax income and any increase in its value is non-taxable.


Studies have shown that from purely an income tax perspective and assuming a constant tax rate for any one individual, the TFSA does not cost the federal or provincial governments any tax revenue when compared to a RRSP. The only difference is when the governments acquire the tax revenue (whether now or later). The TFSA does cost our governments some tax revenue when compared with Open accounts because investment income from an Open account which would have been taxable by comparison is not taxable if received from a TFSA (but this cost is really not significant compared to the total government budget).


The 2015 federal budget increased the annual TFSA contribution limit from $5,500 to $10,000 (and now the lifetime limit to date is $41,000). This increase has been controversial. Many believe it benefits only the wealthy since the average middle-income earner would not be able to afford to save $10,000 per year. The truth depends on individual circumstance. A person with net worth greater than $1 million may view the $41,000 TFSA limit as insignificant. However, a middle-income earner with existing "Open" savings of $41,000 to transfer into a TFSA would perceive the TFSA as a fantastic opportunity to reduce income tax and keep more of their money. Tax fairness between wealthy and middle-income earners is forever debatable. This is not the loophole with TFSA's.


To understand the loophole, consider this scenario (we'll ignore inflation). If a person starts at age 25 to contribute $5,000 per year to their TFSA and if they earn an average annual return of 7% (historically very possible with equity investing) then by age 65 they will have about $1 million in their TFSA. From this they could withdraw retirement income of about $80,000 per year and pay no tax. Some may believe this would not be fair, yet the person invested with diligence and discipline according to the rules and arguably deserves their reward.


Continuing the same scenario, if the person has no pension or RRSP (RRIF) then their taxable income during retirement may be only their CPP retirement benefits and Old Age Security which combined may be about $18,000. Remember TFSA withdrawals do not appear on a tax return. This person would have a low "Net Income" so they would qualify for the GST Credit and about $200 per month Guaranteed Income Supplement (social assistance for seniors). In Ontario, they would receive the Sales Tax Credit and the Property Tax (Rent) Credit and, if they own their home, they would also receive the $500 Ontario Senior Homeowners' Property Tax Grant. This senior person would be receiving about $100,000 per year income yet pay no tax and also receive about $4,000 per year in government benefits and credits!


The loophole results from the exemption of TFSA withdrawals in calculating all government benefits and credits which are determined and paid separately after a person's tax return is filed.


There is a solution to this loophole. Financial institutions already report to the Canada Revenue Agency (CRA) by the end of February each year the sum of contributions and withdrawals for each TFSA for the prior calendar year. They would also need to report the balance of each TFSA at the end of the calendar year. As they do now, the CRA would determine the annuitant's TFSA contribution limit for the new calendar year. The CRA would also calculate how much of the annuitant's net TFSA withdrawal during a tax year is considered "TFSA realized gains" (the growth portion of withdrawals taken during the year, excluding the contribution portion). After an individual files their tax return the CRA would add the "TFSA realized gains" to the individual's Net Income upon determining eligibility for the GST Credit, the Ontario Trillium Benefit including the Sales and Property Tax (Rent) Credits, the Child Tax Benefit, and for seniors the Guaranteed Income Supplement and the Ontario Senior Homeowners' Property Tax Grant. This solution will prevent people with high withdrawals of "TFSA realized gains" from receiving government benefits and credits.


Jeffrey Sindall is a Financial Advisor and owner of Abbington Investments in Hamilton, Ontario.