Gordon Powers

Although the Tax-Free Savings Account is still less than two years old, close to five million Canadians have signed up for one. Too bad so many of them remain unclear as to just what they're supposed to do now — to say nothing of the millions who simply didn't enrol in the first place.

According to a recent poll from Mackenzie Financial, a great many people simply don't get the TFSA at all. Roughly 42 per cent say that lack of knowledge is the primary reason for their not having opened an account yet.

What's worse, 57 per cent of respondents didn't know that contributions grow tax free inside the TFSA; 64 per cent were unaware that unused contribution room can be carried forward; and 78 per cent were unaware that while you can own multiple TFSA accounts, your total contribution is limited to $5,000 annually.

This probably explains why the government is considering giving an amnesty to 70,000 Canadians who inadvertently exceeded that limit recently. It seems most of them chose to interpret the word "account" (I would have called it a plan from the outset) a bit too loosely.

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They didn't seem to realize that you can't withdraw your savings and tax-free profits, and then a bit later just put the money back into the account. Any withdrawals from a TFSA, while tax-free, do increase the available TFSA contribution room — but only in the next calendar year.

Nor, it seems, did most financial institutions do enough to warn customers about the risk of tax penalties if they moved too much money around.

All of which means that the financial industry has to do a better job of explaining this young tax-sheltered product, maintains Wilmot George, Mackenzie's director of tax and estate planning, speaking at a recent conference directed at financial planners.

And he's right. The TFSA is a welcome addition to an all-too-short list of tax shelters, particularly when you consider that you can protect an extra $5,000 from taxes ($10,000 for couples) each year.

Even better, unlike certain tax breaks that dry up each December, the TFSA rules allow you to play catch up. Whenever you don't make the full annual $5,000 contribution, you can carry that contribution room forward and use it any time in the future.

You can also contribute to a spouse's TFSA without affecting your own contribution room. Income attribution rules, which currently govern RRSPs, don't apply here.

Nor do you actually have to have any earned income to be able to contribute, a boon for retirees. TFSA funds can come from a number of sources, including gifts, inheritances, lottery winnings, or tax refunds.

True, that initial contribution amount may seem small, but it's renewed annually and indexed to inflation where it will be rounded up to the nearest $500. And that happens every year, for life.

Also, there's no deadline for re-contributing any amounts withdrawn. This differs from an RRSP where money taken out under the Home Buyers' Plan or the Lifelong Learning Program has to be repaid within a certain time period or else the amounts withdrawn become fully taxable.

But even if investors are slowly becoming aware of these TFSA's advantages, very few of them understand the estate planning implications of what they're buying, George warns.

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This could be another problem in the making, considering that the majority of TFSA holders are over the age of 65.

Not that this is a big surprise. That's where the money is to begin with, and income from a TFSA, unlike RRSP or RRIF withdrawals, doesn't affect means-tested benefits like Old Age Security — a major concern for many affluent pensioners.

If you name a spouse or common-law partner as a successor to your TFSA account, they will acquire the entire amount on your death, regardless of whether they have TFSA contribution room or not, George explains.

Naming the successor holder this way ensures that income earned after your death is not taxed. Without a named successor, any income earned inside the TFSA will otherwise be taxed after the holder dies.

If you designate a beneficiary who isn't a spouse or common-law partner, tax free amounts that have accrued before death pass to the beneficiaries without tax. In that case, the accrued income in the TFSA is also passed to any beneficiaries tax free. Income growth after death but before any such transfer is taxable, however.

The rules in Quebec are a bit different, however. There, TFSA transfers at death will pass through the deceased's estate and will be governed by the will, George points out.

I expect that TFSAs will be a major component of most financial plans in years to come. That's why it's important for both vendors and customers to get the rules straight right now.