Of all the new tax legisla-tion to come out of the federal budget this year, there was arguably none more significant, in terms of long-term impact on individual Canadians, than the tax-free savings account.

“This is the biggest development in registered products since the RRSP was introduced 50 years ago,” says Jeff Greenberg, vice president of financial advisory support with Toronto-based RBC Dominion Securities Inc. “It’s going to be pretty popular.”

In the short term, the TFSA is likely to have only a modest impact on most clients’ financial planning. The true power of this flexible program is in its potential to boost savings over time.

Getting a handle on the TFSA’s potential begins with understanding how it works. As of Jan. 1, 2009, Canadian residents aged 18 and older will be able to contribute up to $5,000 to a TFSA every year, with no age limit on receiving this yearly contribution room. There’s no tax deduction for TFSA contributions, which are made in after-tax dollars, but investment income in the account grows tax-free. Any amount can be withdrawn from a TFSA at any time, for any reason, and won’t be taxed. Withdrawals won’t affect income-tested benefits and credits. And unused contribution room can be carried forward indefinitely.

The TFSA’s potential — a product of compounding investment returns and favourable tax treatment — can be seen over the longer term. For example, a $5,000 contribution to a TFSA in 2009 that is invested in a fixed-income vehicle paying 5% a year, would grow to $13,266.49 by 2029. In comparison, $5,000 invested for 20 years at 5% and taxed at a notional rate of 50% in a non-registered account would grow to $8,193.08, a difference of $5,073.41.

Financial services firms have recognized the potential of the TFSA. A report released in September by CIBC World Markets Inc. suggests that by 2013, Canadians will have a total of $115 billion in TFSAs, with approximate tax savings of $2 billion. Demographics and wider economic trends, the report suggests, will lead to a jump in the overall national saving rate in the next few years, and the TFSA will be part of that phenomenon.

Since the TFSA was announced in the February budget, Canada’s banks, insurance companies, credit unions and wealth-management firms have been busy setting up back-office systems to support their TFSA programs. They have also been providing advisors with information on the TFSA and strategies to incorporate the program into their clients’ portfolios. Financial services firms will rely primarily on advisors to educate clients and make sure they understand the account’s potential. (See page B4.)

However, there are several aspects of the rules and regulations governing the TFSA that haven’t been well publicized and are not well understood. Here are some of the notable ones:

> Contribution Room. Any amount withdrawn from a TFSA in a year is added to the holder’s contribution room for the following year. For example, if a client contributes the maximum $5,000 in January 2009, and then withdraws $2,000 in June 2009 to spend on a holiday, that $2,000 amount will be added to the contribution room for the next year, giving that individual $7,000 in contribution room in 2010 — his or her $5,000 yearly contribution room plus the $2,000 room created by the withdrawal.

Any amount can be withdrawn from a TFSA — contributions and growth in investment returns — and that entire amount is added to future contribution room. That means that, in effect, there’s no limit to how much the contribution room can grow.

For instance, an investor contributes $5,000 to a TFSA and, through successful investing, the original contribution grows to $10,000. If the investor then withdraws $7,500 from the account, that amount is added to next year’s contribution room.

The upside to this is that the more TFSA contribution room a client has, the more flexible the plan becomes. Money can be withdrawn to spend on a purchase or for any other reason. In turn, that frees up room for new funds to be contributed in future years and those funds are shielded from taxes.

Of course, if a TFSA holder invests poorly — say, that the original $5,000 investment dwindles to $1,000 — that contribution room is gone. And investors can’t claim capital losses on investment losses in a TFSA.

@page_break@> No Attribution Rules. The Canada Revenue Agency generally treats any income earned on transferred property as income of the person who transferred that property, and that person is liable for taxes on that income. Under the rules governing TFSAs, spouses can contribute to each other’s TFSAs without triggering attribution rules. A spouse can contribute $5,000 to his or her own TFSA, and contribute another $5,000 to his or her spouse’s TFSA, thereby sheltering more of the couple’s funds from taxes.

> Open To All. Any resident of Canada — not just citizens — can open and contribute to a TFSA. However, how foreign governments will treat income earned in a TFSA by their citizens living in Canada is not known. U.S. citizens and U.S. “green card” holders, for instance, are taxed on their worldwide income. (See page B16.)

Although the RRSP is recognized by the U.S. Internal Revenue Service as a tax shelter under the tax treaty between Canada and the U.S., the TFSA is not.

“We’ll have to wait for a definitive answer [on that question] from the IRS,” says Dave Ablett, senior tax and retirement specialist with Investors Group Inc. in Winnipeg.

> Non-Residents. A Canadian resident who leaves Canada can continue to hold a TFSA and enjoy tax-free growth on any funds in the account. When these now non-residents withdraw funds, they aren’t subject to withholding taxes levied by the Canadian government. However, non-residents are effectively barred from any new contributions, as any such contribution will be taxed at a rate of 1% a month.

> Collateral. Unlike an RRSP, a TFSA can be used as collateral for a loan. Rather than, say, opening an unsecured line of credit with a bank, a client can get a lower interest rate on a secured loan using the TFSA as collateral. However, the interest on money borrowed to invest in a TFSA is not tax deductible, which is similar to the rules governing money borrowed for RRSPs.

> Indexed To Inflation. The TFSA contribution amount is indexed to the rate of inflation, with the amount being rounded up to the nearest $500. If you assume a modest inflation rate of 2%, says Ablett, by 2011, the TFSA contribution room will be rounded up to $5,500.

> No Limit On Number Of TFSAs. As with RRSPs, a client can open as many TFSA accounts as he or she would like, although his or her total annual contribution room stays the same.

Experts suggest that some Canadians could find it useful to have two or more TFSAs, to hold funds meant for different purposes. One TFSA could represent an emergency fund, for instance, while another represents savings for a big purchase.

> Transferring Assets In Kind. The rules for transferring assets in kind into a TFSA are the same as those for RRSPs: if there’s an accrued gain on the asset being transferred, it’s recognized at the time of transfer; if there’s an accrued loss, that loss is not recognized.

“You’re better off selling the security, then putting the money into the TFSA,” says Jason Safar, partner in the tax services practice of PricewaterhouseCoopers LLP in Mississauga, Ont. “I’m sure, virtually certain, that someone will make that mistake. It’s one of those small rules — I see it every year.”

> Age Of Majority. Although every Canadian who is 18 and older will receive $5,000 in TFSA contribution room, not every 18-year-old may be able to open a TFSA account. That’s because in British Columbia, New Brunswick, Newfoundland and Labrador, and Nova Scotia, as well as in the three territories, the age of majority is 19, not 18 as it is in the other six provinces.

“Typically, minors aren’t able to open registered accounts through their financial institutions until they reach the age of majority in the province in which they reside,” says David Birkbeck, head of registered product strategies with Royal Bank of Canada in Toronto.

> Death Issues. A holder can name his or her spouse or common-in-law partner as a successor accountholder of the TFSA. When the original accountholder dies, his or her spouse steps in as the new owner of the account, which remains tax-exempt. Or, if the surviving spouse already has a TFSA, the money in the deceased’s TFSA can be rolled into the surviving spouse’s TFSA without affecting contribution room.

When the surviving spouse dies, the TFSA loses its tax-exempt status and the money and investments in the account become part of the deceased’s estate.

It isn’t possible yet to name a beneficiary to a TFSA. The naming of beneficiaries falls under provincial jurisdiction, and so far no province has amended its legislation to allow it. Being able to name a beneficiary would allow the TFSA to avoid probate in the provinces in which probate is an issue, and would prevent the TFSA from being included in the estate, and thus be subject to fees and taxes.

“There is lobbying going on right now across all the provinces,” says Jamie Golombek, managing director, tax and estate planning, with Toronto-based CIBC Private Wealth Management, “to get them to amend the provincial legislation.”

Most experts, including Golombek, are cautiously optimistic that the provinces will allow beneficiaries for TFSAs to be named, as the provinces allow it for other registered programs such as RRSPs and RRIFs. IE