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	InfoFlash is an electronic publication to keep you informed about emerging business news as it happens. Feedback? Related Publications 2008 Federal Budget: Introduction of the Tax-Free Savings Account 2008 Budget Speech Budget in Brief Budget Plan Profit Sharing Council of America Roth 401(k) Survey 2007 Consumers go it alone as storm clouds gather

One of the most interesting announcements contained in the 2008 Federal Budget was the introduction of the Tax-Free Savings Account (TFSA). Beginning in 2009, the TFSA will have a profound impact on savings patterns, as Canadians 18 and over will be able to start contributing up to $5,000 of after-tax dollars annually to these accounts. Group TFSAs may also come to form a valuable part of the total compensation package offered to employees.

Considerations for Employers

The introduction of the TFSA gives rise to a number of interesting strategies for employers. Sponsors of Group RRSPs, defined contribution (DC) plans, deferred profit sharing plans (DPSPs) and employee profit sharing plans (EPSPs) will need to review their current offerings to determine if a TFSA will complement the existing programs.

We are confident that a market will develop in setting up group TFSAs, sponsored by employers for their employees and potentially, their retirees. Advantages of employer-sponsored group TFSAs would include the following:

• Immediate welcome relief by offering up a tax-sheltering vehicle for retirement contributions that currently cannot be tax-sheltered through registered plans; typically, any excess now goes to taxable savings plans;
     
• The opportunity to encourage further employee savings through supplemental contributions in a group program, allowing employees to access more favourable investment funds than they might be able to buy on their own;
     
• Employees would benefit from their employer’s oversight of the investment fund managers and plan administrators, and from automatic inclusion of TFSA balances in the retirement income modelling tools provided by the plan administrator;
     
• Combining TFSAs with existing employer-sponsored savings vehicles would reduce administrative and management fees compared to TFSAs offered by outside parties (banks or other retailers) and obtained individually by employees;
     
• A TFSA can be used to tax-shelter investment earnings on an Employee Stock Ownership Plan, provided employees have unused TFSA contribution room.

However, employers may face a number of obstacles in integrating TFSAs into their retirement program, including:

• The introduction of an employer-sponsored TFSA on top of several existing savings plans may cause more confusion for employees lacking sufficient investment or financial knowledge;
     
• Introducing a TFSA will require additional communication to employees to inform them of their options, leading to potential employee education challenges;
     
• TFSAs will likely be classified as Capital Accumulation Plans (CAPs) and as a result, employers will have to ensure that the operation of a TFSA complies with the guidelines introduced by the Joint Forum of Financial Market Regulators;
    
• Employers may have to rethink their role in employee income security – the accumulation of unused annual contribution room, the lack of tax on withdrawals and the easy accessibility to the assets may make TFSAs the preferred option over voluntary contributions to Group RRSPs or pension plans. Employers who permit voluntary employee contributions to a retirement arrangement may need to restructure their communication to employees with respect to these choices.

A New Way to Save

The TFSA provides a way for Canadians to save for a variety of life events, including retirement. The benefits of a TFSA compared to existing retirement savings options will depend on an individual’s tax bracket. For example, while those in the lower marginal tax brackets may generally prefer to contribute to a TFSA rather than an RRSP, the reverse will be true for many individuals in middle tax brackets. For high-income or older Canadians who are constrained by the fixed dollar limits in their other tax-sheltered vehicles, such as a Group RRSP or pension plan, the TFSA can be used to increase retirement savings.

Marginal tax rates and clawbacks of public income security benefits mean that TFSAs will provide certain individuals with better long-term savings value than traditional RRSPs. Taking into account federal income tax levels and clawbacks and varying provincial income tax levels, TFSAs will be more effective than RRSPs for employees in the lowest income bracket. Individuals in high income brackets may also prefer the TFSA to traditional RRSPs and pension plans.

The chart below shows ranges of marginal tax rates for individuals in various income brackets depending on their province of residence. Since both a TFSA and an RRSP provide tax-free accumulation of investment earnings, the question of which can produce greater after-tax retirement income will depend on whether marginal tax rates are higher when the funds are contributed or when they are withdrawn. The chart suggests that individuals at both extremes of the income scale would be better served by maximizing TFSA contributions before contributing to RRSPs. Low income earners – those earning less than approximately $37,000 per annum with expected post-retirement taxable income of up to $26,000 – would avoid the 50% clawback in their Guaranteed Income Supplement (GIS). The same is true for high income earners – those earning from $108,000 to $150,000 per annum with expected post-retirement taxable income of $65,000 to $105,000 – at least to the extent required to keep post-retirement taxable income below the Old Age Security (OAS) clawback tax threshold of $64,719.

This simple review of marginal tax rates suggests the majority of income earners in the medium income tax brackets (from approximately $37,000 to $108,000 before retirement and from $26,000 to $65,000 after retirement) would benefit more from continued contributions to RRSPs, assuming that marginal tax rates stay at their current levels in the future. Contributions to RRSPs, as compared to a TFSAs, will allow taxpayers to shift retirement income into a lower tax bracket. Very high income earners who can maintain their post-retirement income between $100,000 and $120,000 would also benefit more from continued contributions to an RRSP versus a TFSA. However, it is likely that these individuals will be able to maximize contributions to both types of plans.

Effective marginal tax rates by income category  

*      Projected as 60-70% of pre-retirement income
**    Includes GIS and OAS clawback and phase-out of refundable tax credit for seniors (known as the "Age Amount")

 

TFSAs may become the first choice savings vehicle due to their versatility and easy access, while RRSPs and other registered DC plans may become a “second tier” of savings. Retirees with extra income could also take advantage of the less stringent rules governing TFSA contributions and withdrawals to build more savings, even past the age of 71, when RRSP contributions must be withdrawn.

The US and UK Experience

TFSAs share a number of similarities with the Roth IRAs in the United States and Individual Savings Accounts (ISAs) in the United Kingdom.

In the United States, designated Roth contributions are not pre-tax, although employer matching contributions are treated as such. Contributions are maintained in a separate account where earnings grow tax-free, and qualified distributions of Roth amounts are not taxed. Roth contributions count toward the single $15,500 yearly limit on elective deferrals for 2008. While Roth IRAs are still a relatively new phenomenon, according to a recent survey from the Profit Sharing Council of America (PSCA), more than 22% of the plans surveyed offered a Roth IRA and over 50% were considering whether or not to add a Roth option to their 401(k) plan. Almost 8% of all eligible employees were making Roth contributions. Employees with less service time have been more active in making contributions than longer-serving employees.

It appears from the Roth experience that employers have been slowly adding Roth IRAs to their employee offerings, and employees are slowly adding Roth IRAs to their investments. While we expect TFSAs to be immediately popular amongst individuals who already have non-registered savings, the US experience suggests it may take a few years for employer-sponsored group TFSAs to become commonplace.

In the United Kingdom, ISAs are investment vehicles available to any UK resident 18 or over. The maximum annual contribution is £7,000 per individual and can be put into a cash account, insurance policy, or stocks and shares. Individuals are not required to pay tax on income received from ISA savings, investments, or capital gains arising from investments. Money can be removed at any time without tax consequences. Unused ISA contribution room can be carried forward.

ISAs are offered by a number of different institutions, including banks, insurance carriers, fund managers, and supermarkets. According to reports, ISAs have proven to be extremely popular, with more than one out of every three eligible investors holding an ISA. Corporate or Group ISAs remain in the development stage.

Issues to Consider

The introduction of TFSAs will have a profound effect on how Canadians save. While the advantages of the TFSA are more readily apparent with respect to short-term saving goals, there are numerous factors that come into play when measuring the value that TFSAs offer regarding retirement savings versus traditional RRSPs.

TFSAs also have implications for sponsors of defined benefit (DB) plans since the TFSA now offers employees another way to save for retirement. Depending on the workforce, the employer may now be able to concentrate more on a DB design that meets the employer’s objectives without being overly concerned whether the plan design minimizes the pension adjustment (PA) and thereby allow the employees to take full advantage of RRSP contribution room.

Employers will face challenges in incorporating TFSA components into existing employee savings plans, and individual employees will have to carefully consider the advantages and drawbacks of this new vehicle. Based on the slow but steady growth of Roth IRA participation in the United States in the two years since their introduction, and the popularity of ISAs almost a decade after their introduction in the United Kingdom, we expect the change in investment philosophy will occur gradually amongst Canadian taxpayers.

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Please contact Dean Taylor , Doug Chandler or your Watson Wyatt consultant for additional information.

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