TFSA tax advantage should be extended to life annuities, groups say in pre-budget pitch

Ottawa should allow Canadians to hold life annuities in their tax-free savings accounts as protection against outliving their money.

That’s the recommendation for the federal government from Toronto-based economic think tank the C.D. Howe Institute and insurance industry group the Conference for Advanced Life Underwriting (CALU) ahead of next week’s budget.

The Income Tax Act prevents people from holding a non-commutable life annuity in a TFSA. Term-certain, commutable annuities are generally allowed.

In contrast, converting investments held in a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF) into a life annuity is permitted. When someone converts assets held in an RRSP or RRIF to a life annuity, they’re no worse off tax-wise: payments are fully taxable, the same as income withdrawn from an RRSP.

However, the only way to convert TFSA savings into a life annuity is to withdraw money from a TFSA and buy the annuity outside of the registered plan. In a non-registered annuity, the interest portion of the payout is taxable.

This inconsistency in tax rules disadvantages people who save for retirement through TFSAs, says Alexandre Laurin, vice-president and director of research at the C.D. Howe Institute.

More Canadians contributed to TFSAs – and in larger amounts – than to RRSPs, according to Statistics Canada data for 2023, the most recent year available.

“The tax rules shouldn’t be what drive decisions. They shouldn’t [keep] people away from a good option,” Mr. Laurin says.

A life annuity is a product insurers sell that gives the buyer a guaranteed monthly income for life in exchange for a lump sum, protecting against longevity risk.

The C.D. Howe Institute said in its shadow budget released last week that allowing Canadians to own life annuities in TFSAs would be a step toward eliminating inefficient or unfair taxes.

CALU made a similar pitch in its pre-budget submission. Specifically, it said Canadians should be allowed to hold a non-commutable life annuity in their TFSA when they reach a specified age, such as 60 or 65.

Holding a life annuity within a TFSA offers two tax advantages, says Stuart Dollar, tax advisor with CALU.

There would be no taxes on the annuity payout in the TFSA because TFSA withdrawals are tax-free; as a result, the TFSA holder’s net income would be lower than if they received payouts from an annuity owned personally.

As a result, Canadians who hold an annuity in a TFSA would pay “less tax on the same income [and their] access to certain government benefits will not be adversely affected,” Mr. Dollar says.

Those benefits include Old Age Security payments, which may be clawed back when someone earns a high income.

However, Mr. Dollar says there would be tax and financial planning drawbacks to holding an annuity in a TFSA, as doing so could be an “inefficient use of the TFSA’s attributes.”

One drawback is that the return of capital portion of non-registered annuity payouts is already tax-free, negating part of the benefit of holding the annuity in a TFSA.

Another is that as annuity returns are guaranteed, they tend to be lower than returns that could be realized in non-guaranteed investments.

“Given the limits to how much you could contribute to a TFSA, it could make sense to shelter high-return investments in a TFSA and leave the lower-return investments in non-registered form,” he says.

CALU also called on Ottawa to allow Canadians to contribute to RRSPs for longer before converting them into RRIFs.

Canadians’ interest in annuities has increased in recent years, says John Natale, head of tax, retirement and estate planning services, wealth, at Manulife Investment Management Ltd.

As long-term government bond rates have risen, so too has the potential payout insurers can offer on an annuity, says Mr. Natale, who wasn’t commenting on the proposal to allow annuities in TFSAs. Insurers calculate payouts based partly on their anticipated returns on conservative investments over time.

Converting some retirement savings into an annuity can be helpful for Canadians without access to a defined-benefit pension plan and those who want to eliminate market risk, Mr. Natale says.

“It is very possible for you to run out of money in your RRIF at ages that many people will outlive, especially if you’re in conservative investments,” he says. “An annuity takes away that risk.”