Since the federal government launched them two years ago, a couple of things have become clear about Tax Free Savings Accounts: Canadians like them, and they are confused about them.
A recent survey by BMO Financial Group indicates that while 36% of Canadians have opened a Tax Free Savings Account (TFSA), they know little about the wide range of investments that can be held within these plans.
The survey, which was conducted by Leger Marketing and released Nov. 9, found that only 20% of respondents knew that mutual funds could be held within TFSAs and only 26% knew that GICs could be included. Meanwhile 37% of those surveyed had no idea what investments are eligible. The survey included 1,513 Canadians who were surveyed between Oct. 25 and 27, 2010.
“While the adoption rate has been swift, we are seeing some uncertainty and confusion among Canadians when it comes to how to make the most out of a TFSA,” commented David Heatherly, Vice President, BMO.
Gordon Pape, author of more than 40 books on investment and money management, including The Ultimate TFSA Guide, and a columnist for The Insurance and Investment Journal, thinks the adoption rate of TFSAs by Canadians “is remarkably good considering these plans have only been available for two years. RRSPs have been around for more than half a century, but according to the CRA only about one-third of taxpayers contribute to them each year.”
Given TFSAs quick popularity, what explains the lack of knowledge about investment options? Mr. Pape says the confusion is due in part to the name Tax Free Savings Account. “The inclusion of the word “savings” seems to have given some people the impression that only savings-type securities were eligible. we should have called them simply Tax-Free accounts. Also, the plans were (and are) heavily promoted by the banks, which understandably focused on savings accounts and GICs.”
Data collected by Investor Economics, a financial services industry research and consulting group, indicates that Canadians who open these accounts at a retail bank branch are primarily investing their TFSA contributions very conservatively, even though these plans offer the opportunity of tax sheltering potentially higher returns from other investments.
This data, collected from surveys of 15 retail bank branches and branchless institutions, shows that as of June 2010 a total of $21.3 billion had been contributed into 5.2 million accounts. Of these assets, $12.2 billion or 57% of TFSA contributions went into savings deposits while another $6.3 billion or 29% went into term deposits (see inset tables on page 8). Mutual funds only garnered 12% of contributions. The data does not include TFSA deposits with life insurers.
Sandeep Gosal, Senior Analyst with Investor Economics explains that the number of accounts opened at the financial institutions surveyed does not necessarily reflect the number of TFSA clients. This is because Canadians are not limited to one TFSA. “Clients can open multiple accounts and they can also do so at multiple institutions… So it’s really difficult for us to determine how many Canadians actually have TFSA accounts,” he explains.
Mr. Gosal also notes that 8.2% of the accounts opened had a balance of zero, which could partly be explained by clients opening more than one account and not contributing to one. Close to half of accounts contained $5,000 in assets or more.
Investor Economics also collected data on the financial institutions’ online discount brokerages and full service brokerage operations. These channels had opened just over a one million TFSAs and collected more than $7 billion in contributions as of June 2010. The breakdown of assets by product for this channel was not available.
Larry Laurendeau, a financial planner with BMO Financial Group based in Vaudreuil-Dorion, Quebec believes that putting TFSA contributions into low interest earning products defeats the purpose of these plans as tax shelters. “You’re not going to defer a lot of taxes on today’s interest rates.”
Earning one per cent interest isn’t going to be detrimental to someone’s tax situation, he continues, especially at $5,000 per contribution. What clients need to understand is that if they want to take some risk in investments with higher growth potential – while remaining within their risk tolerance – the TFSA is the place to do so, he says. This doesn’t necessarily mean equities. Even a bond paying 5% or 6% could be placed within a TFSA. “Anything that’s yielding a good interest or unit return, then a TFSA would definitely be the place to put it.”
Mr. Laurendeau believes the financial services industry is partly to blame for the fact that Canadians are generally using TFSAs as savings accounts.
He says that during the first year that TFSAs were introduced, Canadians were very unclear as to what they could invest in these plans due to name which he considers misleading. Canadians thought TFSAs were bank accounts and financial institutions started catering to this misconception by promoting higher rates of interest in TFSA daily interest savings accounts, he says.
As a result, many people believed that “the TFSA was a product as opposed to being the basket that holds the product… Not too many people know that anything you can put in an RRSP you can put in a TFSA… Everyone kept the focus that it was a daily interest savings account.”
A new name could help clarify the situation, he adds. “I absolutely believe the name should be changed. I think the word ‘account’ is very misleading.”
Doug Frain, a Burlington/Oakville-based financial planner and principal with Millcroft Financial Group, says the economic environment is another factor that has likely led Canadians to put their TFSA contributions primarily into savings accounts. “Part of it I think is the market. Perhaps people are a little bit shell shocked…and a two per cent guarantee looks good…”
Another factor is simply the average person’s lack of financial savvy, Mr. Frain adds. The typical person probably doesn’t spend more than one hour a year reviewing their personal finances, he estimates. “They’d much rather plan a day at the beach than look at their finances. So, they may have heard about this TFSA, but they don’t really know what it is about.”
Mr. Frain says banks’ extensive reach is a third factor explaining the TFSA savings account trend. The banks are filling “a very good role” in getting droves of clients to act on opening TFSA accounts, but bank tellers will advise opening a savings account, he explains.
Mr. Frain has also heard from a number of clients that their accountants have told them to invest their TFSA contributions in savings accounts. The reasoning behind this strategy is that 100% of interest income is taxable, whereas only 50% of capital gains earnings are taxed. What he tells clients is that it is better to earn 8% in a TFSA on capital gains earnings than 2% on interest income.
On the other hand, he adds, if the client plans to use their TFSA for short-term goals, then the savings account approach makes perfect sense.
Mr. Frain says TFSA investing can serve more than one financial planning purpose. Because multiple accounts can be opened, the client may first want to start with a savings account to be used as an emergency fund.
Then money in a second TFSA account, earmarked for long term investing, could be invested in products such as mutual funds or segregated funds.
What can advisors do to help reduce their clients’ confusion with respect to TFSA investment choices? Mr. Pape says education is the key. He suggests sending a letter to all clients at the beginning of the year explaining the range of investment options available. “A client who does not have a TFSA with an advisor may not be aware of all the options and may be motivated to open a new plan when he/she has all the facts.”
What does he think are some of the best investment options for a TFSA? Mr. Pape says this depends on the objective of the plan. “If the account is to be used for emergency savings, the investments should be highly liquid and low risk. If the goal is to maximize the tax savings, aggressively managed mutual funds are a good choice.” In his own TFSA, Mr. Pape has held Front Street Growth Fund, Bissett Microcap Fund and Dynamic Value Balanced Fund.
Does he consider segregated funds as a good option for TFSAs? “Yes, provided they carry a reasonable MER and historic returns are comparable to or better than the category average,” he adds.
Mr. Laurendeau says one way to educate clients is to clearly include it as a key component of a financial plan. Traditionally, advisors have developed client proposals or financial plans that break down investments into registered and non-registered investments. “There should be the third category added to every financial plan which is Tax Free Savings Accounts.” Some people include TFSAs in the non-registered component of the plan, but these should be separate he advises.
Finding the funding
Another way that Mr. Laurendeau is encouraging his clients’ to contribute to TFSAs is to adopt an investment strategy based on maximizing their RRSPs and then using the tax refund to fund their TFSAs. “Essentially you’re having the government fund your TFSA. From there we select the investments according to their risk tolerances and time frames...”
Many clients might choose balanced portfolio mutual fund products for their TFSAs while some will go for riskier investments. Mr. Laurendeau, who holds a securities license, has some clients who put various kinds of stocks into their TFSAs. “When it does grow, or if it splits or if it makes a lot of capital gains…none of it will be taxed.”
Meanwhile, he adds that some clients with significant non-registered assets feel that $5,000 TFSA contributions are not worth bothering with. He cautions these clients that in the years to come their TFSA accumulation room will grow considerably and begin to have a big impact on their financial plans. “We’re going into year three and it is already at $15,000 starting Jan. 1.”