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WHAT IS A TFSA & HOW DOES IT WORK?

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Income taxes can shave off a significant portion of your returns, drastically reducing the amount available for growth. As such, if you can reduce or avoid taxes (legally, of course), it could have a tremendous positive impact on your investment portfolio.

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Government-provided tax shelters are a phenomenal way to reduce your tax burden. The TFSA is a gift from the Canadian Government that can help to shield your investments from taxes.

Let’s unpack the wonder that is the TFSA a little further.

What is a TFSA?

A Tax-Free Savings Account (TFSA) is an investment or savings plan registered with the Canada Revenue Agency (CRA).

It was introduced by the Canadian Government in 2009 to encourage savings.

Although the name implies savings, the TFSA is primarily an investment account. 

It can hold investments such as stocks, bonds, mutual funds, Exchange Traded Funds, Guaranteed Investment Certificates, etc.

You can keep cash in a TFSA, but as you will soon realize, that would not be the account’s most optimal use.

Benefits of a TFSA

  • Any Canadian income earned inside a TFSA is not subject to tax. Such income may include dividends, interest, capital gains, DRIPS, etc. This tax advantage allows your investments to grow faster than they otherwise would in a taxable investment account.

  • Funds in a TFSA are easily accessible. There is no age restriction nor any penalty for withdrawals. This flexibility makes a TFSA an ideal way to invest money for significant near-term purchases such as a home down payment, wedding, car, etc.

  • Your contribution room is not permanently lost when you make a withdrawal. The amount you withdraw is added back to your contribution room on January 1st of the following year.

  • The annual contribution amount is a fixed amount for everyone. It does not depend on your level of income as it does with an RRSP. Lower to moderate-income earners can invest a higher percentage of their total income tax-free.  

  • There are no mandatory withdrawals, and investments can continue to grow tax-free for as long as you wish. In contrast, you have to withdraw from an RRSP when you turn 71.

  • Withdrawals or income earned in a TFSA will not reduce Government benefits such as Old Age Security, Employment Insurance, or Guaranteed Income Supplement.

Limitations of a TFSA

  • Over-contribution will result in a 1% penalty per month on the amount that is over the limit.

  • Income from foreign sources may be subject to taxes. For instance, U.S. companies’ dividends are subject to a flat U.S. non-resident withholding tax of 30%

  • Contributions do not lower your taxable income. Thus, contributing to a TFSA does not provide an immediate tax benefit.

  • Trading activity is not allowed, as the account is intended for long-term saving and investing. Trading activity within a TFSA would constitute a business, and as a result, business income tax rules would apply.

  • Unlike in an RRSP, there is no protection against creditors in bankruptcy or lawsuits for assets within a TFSA.

Rules of the TFSA

While the TFSA is a terrific tax haven for your investments, going against its rules can result in penalties such as audits and, yes, taxes.

Here are the rules to keep in mind and help you stay in the good graces of the CRA.

Eligibility Rules

  • Canadian residents over the age of 18 who have valid social insurance can open and contribute to a TFSA account.

  • Non-residents of Canada for tax purposes who have a valid Social Insurance Number can open a TFSA. However, contributions by non-residents are subject to a 1% tax per month.

Contribution Limits

  • Financial institution such as a bank, credit union, trust, or insurance company provide TFSA accounts.

  • Everyone receives a new contribution room each year, and you can carry any unused contribution room forward to future years.

  • Your contribution room at the beginning of each year is equal to the following:

  • New Room + Unused Room (from previous years) + Previous Withdrawals

  • The new contribution room (limit) is provided each year by the Canada Revenue Agency (CRA). The table below shows the TFSA contribution limits since 2009 to date:

YEAR ANNUAL TFSA DOLLAR LIMIT
2009 to 2012 $5,000
2013 & 2014 $5,500
2015 $10,000
2016 to 2018 $5,500
2019 & 2020 $6,000

  • If you were a Canadian resident over 18 years old as of January 2009 and have never contributed to a TFSA, your total available contribution room in 2020 is $69,500. If that is you, you should start your tax-free investing today!

  • There is no limit to the dollar amount of the holdings inside a TFSA. The only limit is on the amount that you can put in. As such, income earned inside a TFSA does not reduce your available contribution room.

  • Contributions made to a TFSA are NOT tax-deductible. As such, you cannot use them to reduce your taxable income, as in an RRSP. You can learn all about RRSPs here.

  • You can check your available contribution room online at your CRA account. However, note that the CRA website’s amount is valid as of December 31st of the previous year. The CRA online account may not reflect your current year’s contributions.

  • Similar to an RRSP, there is a severe penalty for over-contributing to a TFSA. The CRA will charge a 1% monthly fee on the excess amount, i.e., a 12% annual fee! As such, you need to keep track of your contributions to ensure that you do not over-contribute.

Withdrawal Rules

  • You can withdrawal money from a TFSA account at any time without incurring any fees or tax liabilities. The amounts withdrawn (including any gains!) will increase your contribution room in the year following the withdrawal.

Illustration:

  • Let’s say you contributed $5,000 into your TFSA in 2017 and invested these funds in a growth stock. In 2019, your investment had grown by 10x to $50,000. At some point in 2019, you decided to withdraw $55,000 from your TFSA.

  • Assuming that you contributed your annual limit in all the previous years, your contribution room in 2020 will be $61,000 ($6,000 + $55,000). That is the new room plus previous withdrawals.

  • Withdrawals do not affect your eligibility for Government credits such as the GST/HST credit, Canada Child Benefit, age amount, etc.

  • Further, withdrawals do not reduce your Government benefits such as Employment Insurance, Old Age Security, Guaranteed Income Supplement, etc.

Investment Options

The word savings in TFSA is quite misleading.

In many people’s minds, a savings account implies low-interest rates that hardly keep up with inflation.

However, a TFSA is much more than a savings account. In addition to putting your contributions in an interest-earning savings account, you can also put them to work in various investment vehicles.

You may invest your contributions in:  

  • Cash, Guaranteed Investments Certificates (GICs), and other deposits
  • Most securities listed on a designated stock exchange, including stocks, warrants and options, exchange-traded funds (EFTs), and real estate investment trusts (REITs)
  • Mutual funds (including index funds) and segregated funds
  • Canada savings bonds and provincial savings bonds
  • Certain shares of small business corporations
  • debt obligations of a corporation listed on a designated stock exchange
  • debt obligations that have an investment-grade rating
  • insured mortgages 

Taxes and Penalties

Generally, income within a TFSA is tax-exempt. However, in a few instances, your contributions and earnings may be subject to taxes and penalties. Such examples may include:

  • Earning an income, such as dividends from a foreign country, may be subject to foreign withholding taxes.

  • Over-contributing will result in a 1% per month penalty on the amount above the limit.

  • Making contributions as a non-resident of Canada will result in a 1% tax on those amounts. You will be non-resident if you live outside Canada for most of the year.

How to open a TFSA

If you are eligible to open a TFSA account, you should:

  • Reach out to your financial institution such as a bank, credit union, trust, or insurance company.

  • Provide the issuing financial institution with your Social Insurance Number and Date of Birth to register your account.

You can have multiple TFSA accounts. However, the total contribution to all your accounts should not exceed your available contribution room.

Differences between a TFSA and an RRSP

The TFSA and RRSP are both excellent tax-sheltered accounts that you could use to achieve financial independence. Depending on your goals, one may be better for you than the other.

The table below summarizes the main differences between a TFSA and an RRSP:

  TFSA RRSP
Contribution Limits Annual limit changes each year. Max for 2020 is $6,000 Annual limit equals 18% of the previous year’s earned income, up to a limit of $27,230
Withdrawals Can withdraw at any time, tax-freeWithdrawals can be “re-contributed” in the following years Can withdraw at any time, subject to paying income taxWithdrawals cannot be “re-contributed” except within the HBP* and LLP** programs
Tax Deductibility Contributions are not tax-deductible Contributions are tax-deductible in the current or future years
Tax on Investments Tax-sheltered growth on investments Tax-sheltered growth on investments
Expiration There is no expiry Must be converted to a Registered Retirement Income Fund (RRIF) when you turn 71.
*Home Buyers Plan **Lifelong Learning Plan

In a very general sense, you should invest using:

  • A TFSA if you:
    • Need easy access to your funds (ideal for major near-term purchases),
    • Have maxed out your RRSP contribution or,
    • Are in a low tax bracket (suitable for students)

  • An RRSP if you:
    • Are in a higher tax bracket and can benefit more from a tax deduction in the current year
    •  Want to save for retirement in a tax-efficient way

Common TFSA mistakes to avoid

1. Using the TFSA for risky investments. As investment returns in a TFSA are not subject to tax, it is quite tempting to hold risky assets in this account for the attractive potential tax-free upside. However, capital losses within a TFSA cannot offset future capital gains, should the risky investments in a TFSA become unprofitable. Additionally, a loss permanently reduces your contribution room in the TFSA!

Food for thought: A taxable investment account allows for capital losses to offset future capital gains, softening loss’s blow. Further, only 50% of capital gains in a taxable account are subject to taxes, making investment income inherently tax-favourable. As such, you may want to consider holding your riskier investments in a taxable account instead of a TFSA.

2. Using the TFSA as a savings account. A TFSA is best used as an investment account to take advantage of all its incredible tax benefits. You can hold a wide array of investments in a TFSA such as stocks, bonds, ETFs, mutual funds, GICs, REITs, etc. Such investments would give you a far better return than merely holdings cash savings in a TFSA.

Frequently asked questions about TFSAs

  • Is a TFSA better than a savings account?

Interest income in a savings account is not tax-exempt. However, a TFSA is more advantageous as interest earned in this account is not subject to taxes.

Nevertheless, investing is the best way to maximize the benefits of a TFSA and thus avoid using it as a mere savings account.

  • How many TFSAs can you have?

There is no limit to the number of TFSA accounts that you can have. However, if you open multiple accounts, your total contribution should not exceed your available contribution room.

  • Which is better, RRSP, or TFSA?

The choice between an RRSP and a TFSA depends on your goals. In general, an RRSP is better suited for retirement savings, while you can use a TFSA for any savings goals.

Further, the choice between the two may depend on your level of income.

If you are in a higher tax bracket, an RRSP may be more favourable as it reduces your taxable income immediately. If you are in a lower tax bracket, a TFSA may be more suitable for you as you can invest a higher % of your income tax-free.

  • Can you use a TFSA as an emergency fund?

Due to the tax-free withdrawal nature of the TFSA, you may use it to finance an emergency if necessary.

However, as emergencies can happen at any time, it is best to keep your emergency funds in a savings account for the following reasons:

  1. To avoid selling your investments during a market downturn and thus incurring losses.
  2. Funds in a savings are account are more readily accessible than assets in a TFSA.

  • Should you max out your TFSA?

Next, with fully-funded emergency savings, you should aim to contribute as much as possible to tax-advantaged accounts such as the TFSA and RRSP.

Keep in mind your contribution limit to avoid penalties. Further, be sure to use your TFSA for investing (and not a mere savings account) to tap into its full potential.

  • Can you lose money in a TFSA?

Cash and cash equivalents held within a TFSA are insured up to $100,000 by the Canada Deposit Insurance Corporation (CDIC) should your bank fail.

Funds invested in assets such as stocks, bonds, EFTs, etc. are not insured by CDIC. The more significant concern, however, should be about choosing the right type of investments. If you maintain a well-diversified portfolio, it is unlikely that you could lose all your money.

If you enjoyed this article or have any questions, please leave them in the comment section below! I’d love to hear from you! Also, please feel free to share this with anyone that may benefit from it.

“You see, in life, lots of people know what to do, but few people actually do what they know. Knowing is not enough. You must take action.” ~ Tony Robbins

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TAKE CONTROL OF YOUR PERSONAL FINANCES

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Ever feel like money just seems to slip through your fingers month after month? Our Monthly Budget Tracker will guide you to start making the most of every dollar. It’s a game changer—get it free for a limited time!

Nikki Kirimi

Nikki Kirimi is a finance professional (MBA, CPA, CMA) and the creator of Money World Basics. She is passionate about acquiring and teaching personal finance knowledge to help women achieve their financial goals.