The increase in the tax-free savings account (TFSA) contribution limit to $10,000 from $5,500 will provide Canadians with an opportunity to accumulate tax-free savings at a significantly higher rate over the course of their adult years.
Currently, the tax system permits savings in tax-deferred arrangements such as registered pension plans and RRSPs of up to 18% of earnings, to a maximum dollar limit of about $25,000. By comparison, a $10,000 annual TFSA limit represents about 21% of the average national wage, and is in addition to the contribution room, which applies to tax-deferred plans. Yet only about one quarter of employers who participated in the 2015 Towers Watson DC Plan survey provide a group TFSA in addition to their primary capital accumulation plan. How might TFSAs be used more effectively?
The answer lies in the two features that distinguish TFSAs from other savings vehicles:
- After-tax TFSA contributions are used to accumulate assets on a tax-free basis, which can be drawn down as a flexible source of income which is currently exempt from all forms of taxation, including income-tested government benefits.
- Contribution room is renewed in the year following a TFSA withdrawal, meaning that savings can grow in anticipation of a planned expenditure, and then rebuilt again as individual priorities change.
The first point makes TFSAs particularly attractive for two groups—those with relatively low levels of family income in retirement (i.e., $22,560 or less for a couple) who qualify for the Guaranteed Income Supplement, as well as higher-income seniors (with net income in the range of $72,000 to $117,000) who are subject to the clawback of their Old Age Security pensions. For both of these populations, the TFSA is a tax-effective vehicle for maximizing retirement income.
The “reload” feature of TFSA contribution room makes these accounts appropriate for a broad range of savings objectives. TFSAs are often used as a rainy day fund and they can provide a financial cushion for significant expenses, such as uninsured medical services or upon job loss. Unused contribution room can also be carried forward to future years.
TFSAs can therefore be contrasted with most employment benefit programs, where tax deferral and restrictions on how and when employees can access funds are central to plan design. Unlike pension plans or insured arrangements, TFSAs are not subject to provincial regulation (with limited exceptions, such as upon death or marital breakdown) and are governed primarily by tax law and the CAPSA CAP Guidelines (where member investment choice is provided).
The story of the last decade has been the movement away from traditional benefit designs to lower-cost, flexible approaches that shift responsibility and choice to employees and retirees. TFSAs fit well with this environment and they do not restrict an individual’s opportunity to maximize other forms of retirement savings. It’s time to get creative and consider how best to use TFSAs. For example, directing after-tax bonuses, incentive compensation or even severance pay to a TFSA can earmark these payments as a distinct form of savings or future income that can grow on a tax-free basis.
TFSAs can also assist retirees in managing health costs and the risk of outliving their retirement savings. Many employers have reduced or eliminated post-retirement medical benefits in favour of cash settlements or health savings accounts. Directing assets to a TFSA allows individuals to establish a family medical contingency fund and to budget for such expenditures with minimal administration on the part of the employer.
Retirees with DC pensions and RRSPs can use TFSAs to tax-shelter their savings throughout their retirement. Currently, federal tax rules require Canadians to withdraw funds from their registered retirement income funds (RRIFs) each year after age 71. The budget also lowered the minimum amount that must be withdrawn, which helps avoid the necessity of liquidating much-needed savings when markets are down. With the increase in life expectancy in the general population, TFSAs can be used to both extend eligibility for government-provided benefits and to maximize retirement income in later life, with any residual assets eligible for tax-free transfer to a spouse or children upon death.
There are many ways that TFSAs can be used to support the objectives of employment benefits and compensation plans. The challenge is to help employees understand their choices. This is not a small consideration when so many employees leave money on the table by failing to maximize employer matching contributions to DC plans. With TFSAs, employees first need to understand how these accounts are different from other savings plans, and to be guided to the most tax-effective option. Where TFSAs are earmarked for a particular purpose, it’s also important that plan administrators present investment options suitable for the participants’ risk profile.
There are many different paths on the journey to retirement readiness. TFSAs provide employers with an additional opportunity to offer a supportive environment for building adequate retirement savings and to help employees make smart choices.
Looking for related stories? Read more of our coverage of the 2015 federal budget.
Karen Tarbox is a senior consultant with Towers Watson in Toronto. The views expressed are those of the author and not necessarily those of Benefits Canada.