Will Lindsay be a winner from the Tax-Free Savings Account?

The Honourable James Flaherty has given Canadians 18 years of age or older a new savings vehicle--the Tax-Free Savings Account (TFSA). Savings in a TFSA can grow free of taxes and can be withdrawn without incurring any taxes. The initial annual contribution limit is $5,000 and the limit is indexed to inflation in $500 increments. Unused contribution room is carried forward to future years and withdrawals from the account can be repaid into the account. Any arms-length RRSP-eligible investment is eligible for a TFSA. Less than two years ago the Honourable Flaherty introduced the Tax Fairness Plan that imposed double taxation on the distributions of income trust investments held in retirement savings accounts because of an alleged tax leakage of $500 million. One might wonder why is he now deliberately introducing a new savings vehicle that creates real tax leakage.

Looking at the sales pitch in the budget documents, the new TFSA looks pretty innocuous. The initial contribution limit of $5,000 seems small and the projected bite out of income tax revenue is only $5 million in fiscal year 2009, growing to $50 million in 2010, $190 million in 2011, $290 million in 2012 and $385 million in 2013.

The Budget does not really say why the government is introducing the TFSA. The Honourable Flaherty does say that it provides an improved savings opportunity for low- and moderate-income Canadians to save for cars, homes and cottages; to put something aside for a rainy day; and to save for post-retirement needs. The Honourable Flaherty also says that seniors are expected to get one-half the benefit. The budget gives a number of examples of how the account might be used, including the example of Lindsay. Lindsay is a person of modest income who starts saving when she starts work, uses her TFSA to fund a number of major expenses during her lifetime and still manages to accumulate $130,000 in her account by age 80.

A number of commentators interviewed on the media suggested that the government introduced the TFSA as a sop for investors who had been promised deferment of taxes on reinvested capital gains. The thought was that the promised deferment would be too cumbersome to administer. The TFSAs would be administered by financial institutions for a fee. This is truly a win-win-win situation. The investors win by getting a tax-free savings vehicle, the financial institutions win a new source of fees, and the government wins by keeping investors happy with a device that the Honourable Flaherty can sell to voters as being a wonderful thing for low- and moderate-income families and for seniors.

You will have noticed that low- and moderate-income families and seniors are not included as winners in the win-win-win scenario in the last paragraph. They would only be winners if their overall tax burden is reduced as a result of the introduction of TFSAs. But the reduction in tax revenue that results from TFSAs will have to be funded somehow. The likely source of the revenue to make up for the revenue lost to the TFSAs is income taxes. The introduction of tax loopholes such as the TFSA does not reduce taxes overall, it only serves to shift tax burden between groups of taxpayers. For each tax loophole there are winners and there are losers.

The Honourable Flaherty has assured us that the TFSA will provide low- and moderate-income families an improved savings opportunity. But the higher tax rates resulting from the TFSA mean that low- and moderate-income families will have less money available to save. This is certainly not an improved savings opportunity for low-income families who are already stretched to the limit. They will have little or no money to put in TFSAs and are obvious losers from the introduction of TFSAs.

In the budget example of the moderate-income Lindsay the situation is a little more complex. Lindsay, at age 80, will have the income from $130,000 of investments on which she is paying no income taxes so she is likely to feel that she is a winner. But she is only a winner if those tax savings are greater than the increased amount of taxes she has to pay on other income as a result of the higher tax rates. If the high-income families, which the budget is careful not to mention, manage in total to save more in taxes than is borne by the increased burden on the low-income families, then persons of moderate income like Lindsay will have to pick up part of the burden.

Lindsay is really a very ineffective saver. Persons of moderate income who are good savers can quite easily put away $5,000 per year in a TFSA during their working life. Over a sufficiently long term, equity investments are expected to earn an average annualized return of about 10%. Suppose that you put $5,000 per year in your TFSA starting at age 25, earn 10% per year, and make no withdrawals. Then when you retire at age 65 you will have accumulated $2.2 million in your TFSA. If you continued to earn 10% during your retirement, you could then have a tax-free $220,000 per year to spend and still leave your heirs a tidy sum when you die.

A long-term investment in a diversified stock portfolio carries quite a low risk. If you are willing to assume a little more risk, you can leverage your return and do much better than 10%. There are, for example, investment funds (splits) that are structured so as to split their earnings between two classes of units. The senior units might carry a set yield of 5% and have a first claim on the assets of the fund up to the issue price of the units. There are an equal number of junior units that have no set yield but get everything that is left after the claims of the senior units are satisfied. The yield on the junior units will probably be very variable from year to year but over a longer period of time should average out at about 15%. If you saved your money as in the example in the last paragraph but earned 15% instead of 10%, you will have accumulated $8.9 million by age 65.

If you are willing to accept a little more risk, there are off-the-shelf investments that will give you even greater leverage and greater expected returns. There are, for example, ETFs that will give you 200% exposure to the market. If the market provides a 10% return, your ETF return will be 20%. Your TFSA described above invested at 20% will grow to $36.7 million by age 65. Think about it. If you invest this $36.7 million in government bonds yielding an average return of just 3%, you will have a tax-free income of over $1 million per year during your retirement years. And all that for an investment of just $5,000 per year over your working life.

The above examples show that a person of moderate income who is willing to accept a bit of risk can accumulate a sizable sum of money in a TFSA over the period of his working life using just off-the-shelf leveraged investment vehicles. But remember that many commentators suggested that TFSAs were introduced as a sop for investors who wanted deferment of tax on capital gains. The serious investor already has a large pool of capital. His first concern is not to accumulate funds, it is to avoid income taxes. If he is clever enough at avoiding taxes, his pool of capital will grow very nicely. What he needs is a way to get most of his income flowing through his TFSA, even though most of his original pool of capital may remain in a taxable account.

Suppose the investor has $20 million invested in a portfolio of stocks that has an overall dividend yield of 2%. He would like to retain the dividend yield in his taxable account so that he will continue to benefit from the dividend tax credit and funnel all the capital gains through his TFSA. His investment dealer has a lot of other clients thinking along the same line and tailors an investment split fund to exactly fit their needs. The fund is structured with two classes of units as in the example above except that the senior units have a set yield of 2% and a subscription price of $1 million. The junior units have no set yield and a subscription price of $5,000. There are an equal number of senior and junior units. For each senior unit that an investor subscribes for he is entitled to subscribe for one junior unit. Subscriptions can be paid for in cash or by a transfer of shares. For each of the next 10 years the investor subscribes for 2 senior units through his taxable account and 2 junior units through his and his wife’s TFSAs. In just 10 years he will have managed to avoid any taxation of future capital gains realized on his investment portfolio. (The drawback is of course that he will have to pay tax on previously accrued capital gains that will be crystalized by the transfer of his stock portfolio to the split fund. But maybe the investment dealer can figure a way around that too.)

The investor also has a $10 million mixed portfolio of government and corporate bonds having an overall yield of 6%. He has much more income than he needs and is paying huge amounts of taxes on his interest income. He also has two children in their early thirties who he would like to help out. What he would like is a tax-advantaged way of transferring at least a large part of his bond portfolio to his children. Again he turns to his investment dealer and again he discovers that the dealer has just the right product for him. The dealer is creating a split fund that will hold a portfolio of bonds. The senior units of the fund have a subscription price of $500,000 for which the unitholder will receive 20 annual payments of $30,000 consisting of blended interest and return of capital. Once the 20 payments are made the unit is cancelled and the unitholder has no further claim on the assets of the fund. For each senior unit subscribed for, the investor has the right to designate a buyer of one junior unit. The junior units have a subscription price of $5,000 and will receive all excess earnings and the residual assets of the fund. Each year for the next 10 years the investor subscribes for 2 senior units and his children each subscribe for one junior unit through their TFSAs. At the end of 10 years the investor will have effectively transferred most of the value of his bond portfolio into his children’s TFSAs.

The above are just two examples of how investors might use leverage to get huge amounts of otherwise taxable income flowing through TFSAs in just a few years time. Perhaps it can not be done exactly as described above, but be assured the army of accountants, lawyers, tax planners and other professionals in the investment industry will find many perfectly legal ways to channel earnings through TFSAs that are even more effective than those suggested above.

Before answering the question posed in the title to this piece, let us take a brief look at another tax break given to low- and middle-income families and seniors by a previous government many years ago–that is, the inclusion of only one-half of capital gains in taxable income. The rationale for not including all of capital gains in income is that a part of the apparent gain is really inflation and you should not tax inflation. Once a tax loophole is created, however, it gets used in ways that have nothing to do with the original intent. Two of the best known schemes to convert income to capital gains are executive stock option plans that convert executive compensation from employment income to capital gains and share buyback plans that convert dividend income to capital gains. Some conversion arrangements are truly mystifying. Take Energy Split Corporation (ES on the Toronto exchange) for example. It puts distributions from a portfolio of energy trusts through a complex series of transactions and shadow transactions that magically turn the distributions into100% return of capital and/or capital gains.

Canada Revenue Agency provides summary data from tax returns, categorized by income class and by major source of income, that can give us some idea of the size of the shift in tax burden resulting from the capital gains tax reduction and who are the winners and losers. The latest tax year for which data are available is 2005. In that year there were 23.9 million tax filers of whom 16.3 million were taxable. Taxable filers (taxpayers) had total income assessed of $799.4 billion of which $16.9 billion was taxable capital gains (ie, one-half of their total capital gains). Taxpayers in the income classes of $150,000 or more had taxable capital gains of $10.3 billion.. These taxpayers would likely have any incremental income assessed at the highest marginal tax rate which was about 42%. Applying this rate to $10.3 billion of untaxed capital gains and an estimated rate of 25% to the remaining $6.6 billion, gives an estimate of $6 billion for the amount of tax burden shifted as a result of taxing only 50% of capital gains.


The 14.3 million taxpayers who had no capital gains are the obvious losers from the capital gains tax reduction. Included in this group are 10.2 million taxpayers (62.5% of all taxpayers) who had incomes of less than $50,000. The big winners are of course those in the highest income class, those with incomes of over $250,000. Just 76,550 taxpayers in this income class (less than one-half of one per cent of all taxpayers) had 57% of the benefit. Taxpayers whose major source of income was from investments (1.75% of all taxpayers) had 67% of taxable capital gains. The primary beneficiaries of the capital gains tax reduction are therefore, as one might have expected, rich investors. Supposing the benefit to have been funded by maintaining the tax rate on the lowest tranche of income at a level higher than would otherwise be the case, one can conclude that the capital gains tax reduction resulted in a massive shift of tax burden from rich investors to taxpayers whose income was less than $50,000.

The Honourable Flaherty’s budget shows the TFSAs having a tax cost of just $385 million after four full years of operation. This is such a minor shift in tax burden as to be lost in rounding in the government’s financial statements. Let us do our own estimate of what it might be 10 years out. The three major types of investment income that will be impacted by the TFSAs are interest income, dividend income and taxable capital gains. Rich investors do not like interest income because they are taxed on it at the full highest marginal tax rate. Most interest income is earned by moderate-income families rather than by the rich. Moderate-income families will be less able to take advantage of schemes to funnel investment income through TFSAs. Let us say that in 10 years time 50% of interest income disappears into TFSAs. After deducting interest expenses and using an average tax rate of 25% applied to 2005 tax data, this comes to a tax cost of $1.4 billion for interest income. 69% of all dividend income in 2005 was earned by taxpayers whose major source of income was investments. Because dividend income is very favourably taxed, it will probably be the last to disappear into TFSAs. Let us take a modest 30% as the percentage of dividend income lost to TFSAs. At an effective tax rate (after giving effect to the dividend tax credit) of 17% applied to 2005 data this comes to a tax cost of $1.2 billion. In 2005, about 50% of taxable capital gains came from dividends on shares and 50% of that was realized by just 47,080 high income investors. Such investors would have a strong aversion to interest income and so are likely to have their TFSAs available for strategies that funnel capital gains through TFSAs. Say 25% of taxable capital gains is lost to TFSAs. At an effective tax rate of 40% applied to 2005 data this gives a tax cost of $1.7 billion. The total tax cost in ten years is $4.3 billion in 2005 dollars. Inflating this amount at 2% for 14 years gives us a tax cost in 2019 of $5.8 billion dollars. However, the tax cost of some of the existing tax loopholes available to investors will be reduced so the net effect is likely to be less. But 10 years is a relatively short period of time–over the next 50 years one can expect that the major part of investment income will be lost to TFSAs to the huge benefit of rich investors.

Getting back to Lindsay: is she a winner or a loser? In the case of the capital gains tax reduction just about everybody with capital gains is a winner because taxpayers without capital gains vastly outnumber taxpayers with capital gains. This is so because low- and moderate-income families have a strong preference for interest-yielding investments over equity investments. On the other hand, TFSAs will have a strong appeal to all persons with savings even those whose savings are quite small. The take-up rate for TFSAs is likely to be very high. Given the potential for wealthy taxpayers to flow huge amounts of investment income through their TFSAs, it is unlikely that, over a longer time period, low-income taxpayers will absorb all of the tax burden that is shifted away from the wealthy. Ineffective moderate-income savers like Lindsay may be winners in the first few years but will almost certainly become losers in the long run.