The Tax-Free Savings Account, or TFSA, was first introduced to Canadians in 2009 as a new way to save, invest, and reduce taxes.
The good news is that more and more Canadians are starting to use the TFSA. According to the latest BMO Annual TFSA Study, the percentage of Canadians that have a TFSA rose from 56 to 69% in 2018, while the average total contribution increased from $22,008 to $27,053.
Yet, while a majority of Canadians now have a TFSA, most are unable to describe many features about the vehicle. Only 11% were able to identify the new annual contribution limit of $6,000 for 2019, and 40% did not know that there was a tax penalty for over-contributing to a TFSA.
While it’s worrying that many people do not know the basic TFSA facts, it may be because the potential of TFSA accounts are not widely understood.
If used right, a TFSA can save you thousands in taxes in the long run. It’s essentially the the government giving you the opportunity to earn tax-free investment income.
Take a few minutes to understand everything you need to know about a TFSA, and you’ll be able to leverage your own TFSA to its full potential.
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 and had to take a guess, you might think that it’s similar to a cash 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 of a TFSA.
In fact, a TFSA is far from just a place to park your cash and earn 1% tax-free 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 you can add up all the contribution limits from 2009 to 2019 to arrive at a $63,500 contribution limit! It really is never too late to get started with using a TFSA.
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. However, it is important to note that it takes several months for them to process last year’s contributions and withdrawals, and does not show any changes made in the current year. This means the contribution room shown will not be up-to-date if you make frequent contributions or withdrawals.
If you want to ensure you don’t over-contribute, it’s best to keep track of your contribution room 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 to contribute into the other, then you won’t be able to recover the contribution room until next year.
Now, the freedom of being able to withdraw money at any time without 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 dig into your TFSA when in need of 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.
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 TFSA contribution limit, then get ready to pay a 1% fee on the excess contribution for every month that it stays in your TFSA.
TFSA v.s. non-registered investment account
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 a TFSA instead of a non-registered investment account can amount to thousands of dollars saved in capital gains and dividend taxes. While you need to pay taxes on 50% of capital gains at your marginal rate with a non-registered account, you pay no capital gains taxes with a TFSA. Withdrawals from a TFSA are also not 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.
What if you wanted to liquidate your account to make a down payment for a new house at the end of those 20 years? At this point, you would have contributed $100,000 to your TFSA portfolio and earned $104,977.46 in capital gains, meaning your portfolio would be valued at an impressive $204,977.46.
With a TFSA, you can sell your equity and withdraw it all at the same time and incur zero additional taxes.
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 likely maximize your marginal tax rate for that year. If your average marginal tax rate on the capital gains was 50%,
How about if you wanted to withdraw from your investments over time to reduce your average marginal tax rate to 30%? You would still end up saving ~$16,000 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?
Short answer: yes!
Let’s say you contributed diligently to your TFSA 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 from your TFSA, 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. In other words, withdrawing capital gains and dividends increases your contribution room the next year.
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 would not be able to deposit any more money into your empty TFSA until your contribution limit increased the following year. In other words, capital losses do not increase your contribution room.
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., and so you will still need to pay this withholding tax if you earn U.S. dividend income in your TFSA.
Use your TFSA the right way
While the TFSA is great for investing purposes, there are several scenarios in which using a TFSA would not be the best choice.
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, unless perhaps you have excess contribution room you can’t fill yet.
- Holding cash for more than the short-term – There is very little tax benefit from holding cash in a TFSA. By holding cash instead of investments, you are foregoing the potential tax savings on capital gains and dividends from investing that contribution room.
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 a free TFSA account today at a low-cost online discount brokerage.
The best option for this is to open 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.
It’s time for every Canadian to own a TFSA!