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TFSA — what the Tax-Free Savings Account can and can’t do

The new Tax-Free Savings Account looks like a good idea, says this Canadian advisory, but you should also be aware of a few drawbacks.

You can hardly enter the investment pages without tripping over an acronym. RRSP. RRIF. TSX. ABCP (that’s a nasty one — asset backed commercial paper). Sometimes an acronym completely takes over the identity of a company. When’s the last time you heard the name Bell Canada Enterprises used?

TFSA is the latest acronym in Canadian investing. The Tax-Free Savings Account has entered the investor’s lexicon in the latest federal budget. It looks like a great idea. It is, with some reservations. That’s the opinion of one of Canada’s leading advisories on income investments, the Money Reporter.

This advisory also has some advice on Bell Canada Enterprises (or BCE Inc., if you prefer) and one of Canada’s leading income trusts. We’ll cover those first. Then we’ll see what’s good, and what’s not quite so good, about the TFSA.

A Canadian board

For some reason, the BCE Inc. (TSX-BCE) privatization can’t be done quietly and efficiently. (We know a few disgruntled telephone customers who might say that stands to reason.) The latest wrinkle comes from another acronym — the CRTC (Canadian Radio and Telecommunications Commission), which wants to know just how “Canadian” the privatized company will be.

BCE owns ExpressVu, some broadcasting assets in Quebec and a stake in CTV Globemedia. And there’s a fair amount of American money tied up in the deal. Foreign ownership of Canadian broadcasting assets can be no more than 46.7 per cent. Plus the CRTC wants to make sure that the chair is held by a Canadian, that a majority of the board is Canadian, and that the board’s executive committee is also Canadian by majority.

So a hearing was scheduled. Then it was postponed. The head of Teachers Pension Plan has offered to make changes, largely related to who can nominate directors. The hearing is now scheduled to take place this coming Tuesday, March 11.

The advisory’s conclusion: “BCE shareholders should recognize that this postponement will not likely affect the CRTC’s original plan to issue a decision before the end of March. Keep holding your BCE shares.”

Making speeches and money

Almost a year and a half after the income trust tax ruling was tabled in parliament, it’s still not clear how income trusts are supposed to convert back to corporate status.

That is the complaint of Mr. Marc Tellier, CEO of Yellow Pages Income Fund (TSX-YLO.UN). He is, says the advisory, “calling on Ottawa to end the uncertainty over the future of income trusts by providing complete rules on exactly how they are convert to their new corporate status. He’s right; the sooner we all know the better.”

In the meantime, Yellow Pages “does more than make speeches; it also makes money,” adds the advisory.

This publisher of the most-used directory in Canada posted a 39 per cent in fourth quarter earnings for 2007. Acquisitions and growing revenues from online advertisers both contributed to the strong results.

The advisory’s call on Yellow Pages: Buy it and hold it for the long term.

Different in two ways

The Tax-Free Savings Account is just like an RRSP in one respect, says the Money Reporter. Income and gains compound tax-free while they’re in the plan.

It’s different in two ways: First, there is no tax deduction for putting money into a TFSA, as there is in an RRSP. “With a TFSA, the money invested is after-tax money,” says the advisory. “With an RRSP it’s pre-tax money that you are investing.”

The other big difference is that money taken out of a TFSA will not be taxed at all, no matter how much the funds have grown. With an RRSP, every cent you withdraw is taxed as ordinary income, even if it came from dividends or capital gains.

Now let’s see exactly what you are getting with the new TFSA.

Spelling it out

The advisory spells out this new savings plan, detail by detail:

• As of 2009, any Canadian of age 18 or older will be able to invest up to $5,000 per year in a TFSA.

• No taxes will be payable on any investment gains, including capital gains.

• The money in the TFSA can be withdrawn at any time.

• Any funds that are withdrawn can always be put back into the account at a later date without reducing contribution room.

• Any unused contribution room for any year can be carried forward to a future year.

• There is no lifetime contribution limit.

• A person may also contribute to a spouse’s TFSA.

• Assets from a spouse’s TFSA account will be transferable upon death to the other spouse without tax implications.

The advisory sees two big positives in this plan. “First of all, Canada’s savings rate is both dismal and declining, so anything that reverses this trend is welcome in the sense of general economic health.

“Second, knowing that you will never be taxed has a certain appeal.”

But there are three drawbacks that must be noted, in this advisory’s opinion.

Fees, deductions and tax brackets

The first drawback is the contribution limit of $5,000 and how much of that will be eaten away in fees. “It remains to be seen how much the banks and other financial institutions will charge to administer one of these accounts (RRSP fees generally run from $60 to $120 a year),” says the advisory, “but in the first year especially that fee will cut significantly into your return.”

When the account balance gets to $10,000 or $15,000, the fee will constitute a lesser percentage, of course, but it still erodes your return. This also happens with RRSPs, of course, but in most well stocked accounts, the fee takes a much smaller bite.

Next, capital losses won’t be deductible against capital gains. If you lose money in a TFSA, there is no tax cushion to offset it.

Finally, there is this to consider. It’s quite possible that you could be in a significantly higher tax bracket when you put the money into a TFSA than you are when you take the money out. “While contributing to an RRSP under these circumstances would result in a net tax reduction, doing so with a TFSA would actually result in higher net taxes being paid.”

When you consider how the value of your investment compounds, it makes this scenario even less palatable, adds the advisory.

“Don’t get us wrong,” concludes the advisory. “We like the concept of a TFSA. Just know that there are some caveats to it as well.”

It all gets down to another acronym: TTGWTB — Taking The Good With The Bad. All we can do with any investment is decide that the advantages outweigh whatever drawbacks there might be. We all have to accept a little RISK. And that’s not an acronym: it’s the real thing.