Date: April 26, 2012
Title: TFSA confusion
Sub-title: These new savings accounts are among the most tax-efficient wealth accumulation tools. However financial services coops are struggling to market them effectively.
Three years ago the Harper government quietly introduced a new investment vehicle, Tax Free Savings Accounts, which, if they become a long-term staple of public policy, could potentially be one of the most effective wealth accumulation vehicles out there. That’s because unlike Registered Retirement Savings Plans, a more traditional alternative, TFSAs investors don’t just defer the tax they would normally pay on investment income – they are exempt from it altogether.
So it should not be surprising that the new vehicle quickly achieved considerable success and that its popularity is increasing steadily. According to a BMO Bank of Montreal survey close to half (44 percent) of Canadians now hold a TFSA, up from 36 percent last year, a geometrical increase.
That said, according to a variety of sources, the introduction of this new tax planning tool was a lot bumpier than many expected. “During the first two years, members came often to seek clarification,” admits Francine Blackburn, a spokesperson for Mouvement Desjardins. “They were sceptical about the advantages, confused about things like (how to calculate) the contribution room, the unused contribution, and whether you could open TFSAs in multiple institutions. Many were convinced that withdrawals were taxable.”
Gerald Giovannetti, a senior branch manager with League Savings and Mortgage Company, a subsidiary of Atlantic Central agrees. “It seems pretty simple– the program started in 2009 and you are allowed to carry forward $5,000 a year in contributions. That means if you open a TFSA account today you can put in $20,000,” says Giovannetti. “However many clients, particularly those less versed in financial matters, understandably get all mixed up, due to the fact that the carry forward rules and limits on RRSPs and other vehicles are different. As a result, we need to explain the facts carefully.”
Giovannetti and Blackburn’s observations regarding investor confusion with TFSAs are echoed in a variety of industry and non-industry sources. “Our office took notice of numerous media reports on the difficulties experienced by individuals,” noted Paul Dubé, the Taxpayers’ Ombudsman, in a report filed in mid-2011 about TFSAs. “Taxpayers complained to us that TFSA rules regarding withdrawals and over-contributions were confusing (and) we heard from individuals who claimed that the information they received was not clear enough.”
Titled Knowing the Rules: Confusion about the rules governing the Tax Free Savings Account, (www.oto-boc.gc.ca/rprts/rls/rprt-rls-eng.pdf) the report noted key areas in which the Canada Revenue Agency was deficient in informing the public about this new investment vehicle. For example the initial Web-site that CRA set up for that purpose (http://www.tfsa.gc.ca/), provided clients with no explanation of the consequences of over-contributions and withdrawals paid back the same year. To figure that out, site users would have had to leave the site and to find their way over the CRA’s own umbrella site. The report concluded that CRA should have been more proactive in its information supply and that it needs to continue to work with the financial services sector in order to better get its TFSA-related messages out.
The BMO survey cited above echoed the findings regarding TFSA confusion, indicating that more than a third (37 percent) of Canadians had no idea of what investments are eligible to be placed with eligible within a TFSA.
Moving away from negative real returns
The popularity and potential usefulness of Tax Free Savings Accounts stems from an uncomfortable (and often hushed-up) fact related to fixed-income vehicles in recent years: the real rates of return that investors are getting after tax on the money they invest are less than zero. For example as at mid-April the yield curve for Canadian Treasuries ranged between 0.95 percent for three-month issues to 2.1 percent for ten-year bonds.
It’s not a great return, but these days, in the post financial crash and recession agony, investors are prioritizing capital security over income. So the return, on paper, is at least something. However when inflation (which has been bouncing around the 2.0 percent level for the past ten years) is taken into account those returns get wiped out. Then, to add insult to injury, investors have to pay tax on those “paper” profits too, often at the highest personal marginal rates. The plain fact is that most investors who buy bonds, GICs and similar products these days, lose money in real terms.
Investors in equity vehicles face similar challenges. For example between August of 2000 and late last year, the S&P/TSX index remained basically flat, leaving investors with meagre dividend returns as their only income. There too, inflation and taxes (despite the fact that they are lower on dividend than on fixed income investments) pushed real returns below zero during the period. TFSAs will go a long way to help shift that balance, hence their popularity.
What financial services coops are doing about TFSAs
Not surprisingly, Mouvement Desjardins has been a big backer of Tax Free Savings Accounts from the get-go, and the payoffs have been huge. As of March 3rd of this year, the financial services cooperative had $5.8 billion worth of TFSAs in its books. “Our financial planners saw immediately the many advantages that they would bring to members,” said Blackburn. “Especially for those who already had non-registered savings (which could almost painlessly be moved in the TFSAs).”
According to Blackburn, during the first years after they were introduced, TFSA popularity was cyclical, in part because the new option was introduced at the start of the year. But as TFSA promotion initiatives enter their fourth season demand is now constant, increasing throughout the year. Desjardins’ marketing efforts include the use of traditional tools, as well as direct solicitations by the firm’s financial planners and advisors who contact members that have high balances in non-registered accounts.
Which particular strategies are used to market TSFAs, and how those efforts are divided between the regional central unions and individual members in their groupings differ across the country. For example according to Bob Perfonic, director of financial services, at Central 1 Credit Union, the British Columbia trade association provided some support to its 45 individual members including marketing materials such as brochures about TFSAs, information material and the like.
Perfonic’s group also produced a webinar, which explained to personnel what TFSAs were, and how they could be marketed. That said, the bulk of the individual marketing and promotional efforts are made by the central’s individual members. These have clearly been successful, as assets under management at the group (now close to $2 billion, split amongst 200,000 member-TFSA accounts) and the number of new clients, continues to increase.
According to Giovannetti, Atlantic Central, whose 28 credit unions in Newfoundland, Nova Scotia, Prince Edward Island and New Brunswick, currently hold $134 million in TFSA assets, those amounts have been increasing steadily as well. That’s particularly true with regard to the value of assets owned by savers who are more than 45 years old. This should not come as a great surprise because people tend to accumulate assets as they age, and their declining obligations (kids, mortgages) as well as inheritances that begin to flow in from their own parents, leave them more money to put aside. “We do a fair bit of promotion too,” says Giovanetti. “That includes advertising on individual credit union web-sites, use of local print media, some television and the set-up of in-house displays.”
According to Blackburn one of the main areas that financial services cooperatives can work at to help ease TFSA confusion is on front line: branch level client contacts. “Once members know the many benefits associated with TFSAs, they come to ask us how to invest,” says Blackburn. “When they were first introduced our main priority was to transfer as many non-registered savings into them to minimize income taxes. The main focus was to have access to liquid tax free assets for use as an emergency fund. We are now shifting to a more focused discussion of TFSAs as a retirement vehicle, and have started talking about the asset split between different accounts used to fund retirement.” For example Blackburn notes that there is a case to be made that high return assets should be transferred into TFSAs, and low return assets into RRSPs.
Indeed which of the two popular investment vehicles to use is one of the most asked questions, due to the large number of savers that have inadequate resources to take advantage of both. “Our tax specialists give advice on various issues include which account to use,” says Blackburn. “What we tell them depends on two factors: the rate at which contributions can be deducted and the rate at which RRSP withdrawals are taxed, as well as how long savings can accrue.”
Blackburn also notes that the impact of RRSP contributions and withdrawals may impact entitlement to certain credits. She cites the OAS claw-backs as a key obstacle to avoid. And since individual circumstances vary greatly, any advice needs to be highly tailored. “Members who use the TFSA instead of the RRSP also need to realize that, because amounts saved in TFSAs are more easily accessible, their chances of remaining available until retirement age decrease significantly depending on the member’s degree of financial discipline,” she notes. “In short, from a tax perspective, one plan may be more beneficial than the other, or a combination of the two may provide the best flexibility. It all depends on their personal situation.”
Growing in importance?
In a sense, given the low interest rates and projected returns on equities portfolios during coming years, the popularity of Tax Free Savings Accounts could be said to be somewhat surprising. However earlier this month, a development took place which, if it plays out, could vastly increase the vehicle’s popularity even further during the coming months and years.
During its April 17th policy announcement, the Bank of Canada hinted that we could see a gradual withdrawal of the substantial monetary easing that has been in place since the 2008 financial crisis. If this occurs, the central bank’s policy rate will gradually increase from its current low 1 percent base. As it does, many market interest rates, which are influenced by it, could follow suit. In short, an eventual return to more normal bond yields, say in the 5 percent range, is now in the cards over the medium term, a development which could completely change the attractiveness of TFSAs.
One example suffices. An investor who puts aside $50,000 into a TFSA for 25 years at an annual rate of 5 percent, would walk away with $169,318 in his pocket at the end of the period. (http://www.fidelity.ca/cs/Satellite/en/public/education_planning/calculators/growth). However an investor who buys a non-sheltered product, and has to pay 35 percent worth of income tax on those earnings each year, would only have $111,230 at the end of the period. In short, the TFSA investor walks away with $58,000 in extra cash.
If the financial services cooperatives think that their TFSA desks are busy now, just wait until they are able to put those numbers in their advertising campaigns.
Then things could really get going.
Peter Diekmeyer (Peter@peterdiekmeyer.com) is Enterprise Magazine’s Quebec correspondent.
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