What is a TFSA?
Despite its name, a Tax-Free Savings Account is actually not a savings account. It’s more of an investment account. It’s a vehicle where your investments can grow without having to pay tax on the earnings. It can be a little bit confusing which is probably why many Canadians are not using their TFSA to its full advantage.
To back up, when you invest, whether it’s in stocks, bonds, mutual funds, ETFs, yes even term deposits...you have to pay taxes on the interest or any gains you make.
That’s not unfair, it’s just how taxes work.
In 1957, the federal government introduced the registered retirement savings plan (RRSP), an instrument designed to encourage Canadians to save for their future by providing tax benefits.
The RRSP became a crowd favourite and still today is the bulwark of many Canadians’ retirement savings, with lots of benefits that you can discover to make the most of it.
In 2009, the RRSP got a little brother, the TFSA. In the ten years it’s been around, it’s seen a great adoption rate.
As registered accounts, RRSPs and TFSAs are both in the same family so they function in very similar ways. But as anyone who has two children will tell you, it’s amazing how two people can be so similar and at the same time so different.
And the same is true with RRSPs and TFSAs.
How does the TFSA work?
Who can open a TFSA?
To open a TFSA, you have to be a Canadian resident, 18 years old or older, with a valid Social Insurance Number. Unlike an RRSP, there is no upper age limit so you could keep contributing to it well after you turn 100.
How much can you put in your TFSA?
With a TFSA you can invest in mutual funds, term deposits, ETFs or even a savings account.
There is a limit to how much you can put in to your TFSA, and that’s called the contribution limit. Every year, the contribution limit increases (sometimes it increases a bit more) and accumulates, which means that if you don’t reach the limit one year, you don’t lose it.
As you can see in the table below, the TFSA limit for 2019 has gone up to $6,000.
|Year||TFSA Contribution Room||TFSA Cumulative Limit|
Your contribution limit kicks in the year you turn 18 so if you turned 18 in 2017, your total contribution limit in your TFSA in 2019 would be $5,500+$5,500+$6,000=$17,000.
If you had 0$ in your TFSA in 2019, you would be able to contribute not just the annual limit of $6,000, but up to the cumulative contribution room of $63,500 (provided you were over 18 in 2009).
The other thing the TFSA allows you to do is to withdraw money from it without losing your room. So if in 2018, you had $57,500 in your TFSA and you took out $2,500 for a trip, that would leave you with $55,000.
$57,500 - $2,500 = $55,000
You don’t forfeit that contribution room: you are still able to put in an extra $2,500 to meet the cumulative $57,500, although you’ll have to wait until the next calendar year to make that contribution.
This means that you can use your TFSA as a savings vehicle for your short-term goals (trip to Europe) as well as your long-term goals.
What happens if you over-contribute?
If you go over your contribution limit, you’ll incur some pretty steep tax penalties: 1% per month of the amount in your TFSA that exceeds the limit.
What are the tax benefits to using a TFSA?
One of the ways the TFSA is different from the RRSP is that you have already paid taxes on the money you deposit. Your contribution is done with your after-tax dollars.
Use our calculator to see the benefits of investing in a TFSA over a non-tax sheltered investment
With an RRSP, any growth within the portfolio is tax-sheltered and you only pay taxes when you make a withdrawal, which is then taxed as income. With a TFSA, it’s the opposite: the deposits you’ve made have already been taxed as income and when you make a withdrawal, that is tax-free.
That makes it a very flexible vehicle to help you save for the future.
How can you use your TFSA?
There are a lot of ways you can use your TFSA to help you reach your financial goals. Its flexibility allows you to save for short-term and long-term goals so here are a couple of real examples of how you could use your TFSA.
Save for a rainy day
Because your withdrawals aren’t taxed as income, your TFSA is an excellent vehicle in which to park your rainy day fund. You can invest it in a redeemable term deposit (i.e. a GIC) so your deposit is guaranteed and you can cash out if you suddenly need to and your rate will be better than your typical savings account.
Save for a large purchase
If you’re looking to buy a computer, go on a vacation, or even looking to build your Christmas budget so you get to enjoy the next holiday with a bit more ease, you could find much worse places to save up than your TFSA.
Hit the next milestone
Large-ticket items aside, in life there’s always the next big thing. Buying a car, buying a house, building a deck, renovating the kitchen, putting your children through college, helping out with their wedding, the list goes on and on.
Investing in your TFSA gives you the ability to put money aside so you’re financially prepared for when the next big milestone hits.
Buckle down and save for retirement
Some of the advantages of going strictly with a TFSA is that you won’t suffer any clawbacks when withdrawing your money, you won’t have to pay any income tax on it and you’ll be able to continue contributing to it.
At the same time, there is a psychological effect that comes into play when you get taxed for every penny you withdraw like you would with an RRSP that helps adopt more frugal lifestyles.
Most good retirement plans will leverage both the RRSP and the TFSA.
TFSA or RRSP?
Like we said above, you probably can’t build a $1-million retirement fund and save up to buy a boat and build your two-and-a-half kids’ wedding fund all at the same time…
But you can use your TFSA to save for both your short-term and long-term goals. You can structure your portfolio with different strategies which may be short-term, medium-term or long-term.
Priorities also change depending on where you are in life: somebody in their 30’s has different goals from somebody in their 40’s, 50’s and 60’s and that’s also important to keep in mind.
The TFSA will generally work well for those in a lower income bracket (under $30K annual income) as you will not get the best tax benefits by making a RRSP contribution.
When you are in a higher income bracket (over $30K annual income) you may want to use the RRSP as a way to reduce your taxable income.
Ideally being able to incorporate both RRSPs and TFSAs into your overall investment plan will lead to hopefully an earlier retirement and the ability to start working on your bucket list.
For a complete breakdown of the differences between an RRSP and a TFSA, check out our article on the topic.
What are the benefits of a TFSA?
The TFSA is an incredibly useful instrument to help you save for your future, whether for your long-term goals like retirement or for the short-term dreams, like an all-inclusive in Puerto Vallarta.
Here’s a recap of their advantages:
- Flexible vehicle, well suited for long and short-term saving goals
- Your earnings grow tax free
- Your withdrawals are tax free
- Your withdrawals won’t affect your Old Age Security, Canada Pension Plan or Guaranteed Income Supplement
- You can keep investing in them even after you turn 71 (unlike an RRSP)
Although it’s a critical piece in your strategy to save for the future, your TFSA is so much more than just a savings account.
It can become the very cornerstone for your savings plan, the most powerful instrument due to its versatility in helping you enjoy life a bit more.
You don't have to do it alone. Contact one of our financial advisors today and they can help you put together a plan that will help you reach your goals and leverage the proper investment vehicles.