How does a TFSA (Tax-Free Savings Account) work?
Using a TFSA effectively can save you thousands in taxes because the government is giving you the opportunity to earn tax-free investment income.
Yet, many people aren’t aware of how to leverage their TFSA to its full potential.
Take a few minutes to understand how a TFSA works and everything you should know about the Tax-Free Savings Account. You will then be well equipped to take maximum advantage of your own TFSA.
Is the TFSA a savings account?
There’s a common source of confusion when it comes to the TFSA that’s caused by its bewildering name.
If you’ve never heard of it, you might guess that it would be similar to a bank savings account. It has “savings account” in the name – sounds just like a normal savings account, except that you don’t have to pay taxes on the little bit of interest you earn from your cash deposits, right?
Unfortunately, its deceptive name does its best to conceal the true benefits.
In fact, a TFSA is far from just a place to park your cash and earn 1% interest. To truly capitalize on the potential of a TFSA, it should be considered an investment account. Unlike your typical savings account, you can use a TFSA to buy stocks and bonds, not just hold cash inside.
A TFSA is an excellent vehicle to hold long-term investments that will allow you to accumulate wealth through compounding returns.
How much can I contribute to my TFSA?
The amount of money you can contribute to your TFSA is known as your contribution limit. Your contribution limit increases starting from the year you turn 18 years old. The TFSA was introduced in 2009, so if you were over the age of 18 by then your contribution limit would have started growing in 2009.
|Year||TFSA Contribution Limit|
The great thing about the TFSA is that unused contribution limit carries over every year. For example, if you are currently 30 years old and have never used a TFSA before, then adding all the contribution limits from 2009 to 2020, you would have $69,500 in contribution room waiting for you to use!
Keep in mind that you’re allowed to have multiple TFSA accounts, as long as the total amount contributed across all accounts does not exceed your contribution limit.
Similarly, your remaining contribution room is the amount of money you can contribute before reaching your contribution limit. It decreases by the amount that you contribute into your TFSA. When you run out of contribution room, you have reached your contribution limit.
The Canada Revenue Agency (CRA) keeps track of your individual contribution room at the start of every year. To view the contribution room that CRA has on your file, log into your CRA account, and then scroll down to the “RRSP and TFSA” section, where you can view your contribution room as of January 1st of the current year.
It takes several months for CRA to process last year’s contributions and withdrawals. The contribution room shown will not be up-to-date if you make frequent contributions or withdrawals. Check the Transaction Summary to see the contributions and withdrawals CRA has on file.
If you want to ensure you don’t over-contribute, it’s best to keep track yourself by keeping account of your contributions and withdrawals.
How do withdrawals affect my contribution room?
One of the most notable distinctions between a TFSA and an RRSP is that when you withdraw from a TFSA, that contribution room is not lost forever. Instead, the amount that you withdrew is re-added to your contribution room on January 1st of the next year.
Be wary that if you’re transferring money between TFSA accounts by withdrawing from one account and contributing into the other, then you won’t be able to recover the contribution room until next year.
To illustrate how withdrawals affect your contribution room, consider the following example.
The freedom of being able to withdraw money at any time without permanent penalty is theoretically a tremendous benefit over using an RRSP.
In reality, it can be more of a double-edged sword. A TFSA was designed to be a long-term savings vehicle, and the temptation to withdraw for some quick cash can be detrimental to your saving and investing goals. So if you’re planning to save for retirement but find it hard to resist using the money for other things, consider maxing out your RRSP first.
Keep your investments in your TFSA, not your savings
The main benefit of a TFSA is that capital gains, dividends, and all other investment earnings within the account are completely tax-free.
In the long run, using one instead of a non-registered investment account can amount to thousands of dollars saved in capital gains and dividend taxes. With a non-registered account, you need to pay tax on 50% of realized capital gains at your marginal tax rate. With a TFSA, you pay zero taxes on investment appreciation.
Withdrawals also aren’t taxed since you contributed with your after-tax income (unlike an RRSP).
Let’s use the earlier example to compare investing in a TFSA versus a non-registered account. Suppose you planned to invest $5000/year in index funds for 20 years, and averaged a 7% yearly return.
Say you now wanted to liquidate your account to make a down payment for a new house after the 20th year.
At this point, you would have contributed $100,000 to your portfolio and earned $104,977.46 in capital gains, meaning your portfolio would be valued at an impressive $204,977.46.
Now when you sell the equity and withdraw the cash, you’ll incur zero capital gains tax.
The same cannot be said if you tried this with a non-registered account: you would incur a huge capital gains tax liability since the massive withdrawal would land you in a high tax bracket.
How about if you wanted to withdraw from your investments over a few years to reduce your average marginal tax rate to 30%? How much would you save if you used a TFSA instead of a non-registered account?This comparison really demonstrates the potential tax savings you could be missing out on if you don’t use a TFSA.
You should only use non-registered accounts after you’ve maxed out your TFSA and RRSP. Non-registered accounts have no contribution limit.
If my TFSA grows to $200,000 and I withdraw it all, will I gain $200,000 in contribution room?
The short answer: yes!
Let’s say you contributed diligently over many years or were the recipient of good stock picking fortune. Your TFSA has now managed to appreciate to $200,000.
You wont just be paying absolutely no tax when making your big withdrawal.
In fact, every dollar you withdraw, whether it be your initial investment, capital gains, dividends, or interest, increases your contribution room in the following year by that same withdrawal amount, no matter how large.
That’s right – in addition to the principal, withdrawing capital gains and dividends also increases your contribution room!
On the other hand, say your stock picking caused your TFSA to plummet to $0 and you had contributed up to the limit. In that case, you have nothing to withdraw and would not be able to deposit any more money until your contribution limit increases the following year.
U.S. withholding taxes
Canadian are required to pay a 15% withholding tax on dividend earnings from a U.S. stock. The tax-sheltered benefits of a TFSA are not recognized by the U.S., so you will still need to pay withholding tax if you earn U.S. dividend income.
Be careful of over-contribution
Remember that your contribution room does not increase immediately after you withdraw money from your TFSA.
If you exceed your contribution limit, then get ready to pay a 1% fee on the excess contribution for every month that it stays in your TFSA.
Use your TFSA the right way
While the TFSA is great for investing purposes, it should not be used for the following reasons:
Don’t use a TFSA for…
- Day trading – Conducting very frequent trades may be considered as a business activity and instead of investment activity to the CRA. You may lose the tax-free benefits of the account if you’re perceived to be earning business income in your TFSA.
- As an emergency fund – Emergency funds are important to prepare you for sudden unexpected expenses. However, it would be more efficient to put your emergency fund in a traditional savings account. Only put your emergency fund in a TFSA if you have spare contribution room not being used for investments.
- Holding cash for more than the short-term – As stated earlier, there is very little tax benefit from holding cash in a TFSA. Unless you have spare contribution room, you are foregoing the potential tax savings on capital gains and dividends resulting from investing.
Where can I open a TFSA?
Ready to take full advantage of the tax benefits of a TFSA and save thousands of dollars along the way?
You can open one for investing today at a low-cost online brokerage.
The overall best TFSA investing account is a self-directed Questrade TFSA. Along with having one of the cheapest trading fees in Canada, you can hold CAD and USD currencies, allowing you to trade both Canadian and U.S. stocks.
Hopefully you now have a clear understanding of how a TFSA works. Enjoy maximizing your tax savings with your own TFSA!