Better late than never compared to many other countries with similar programs, in 2009 Canada introduced the Tax Free Savings Account (TFSA), which has been largely under-utilized to this day due to its unfortunate misnomer. You see, a TFSA for sure can be used like a traditional savings account, but its best use and true beauty is in its power as a longterm investment vehicle for your financial goals, whether buying a car, renovation, mortgage, or retirement.
Let me briefly explain how it works so you can make better decisions about how to maximize its use in your financial plan.
What Does a TFSA Do?
First of all, a Tax Free Savings Account (TFSA) is one of the CRA’s “registered” investment vehicles, like the venerable RRSP, the family friendly RESP, or the lesser known RDSP. Despite the name, it can be used as either a savings or investment account, and its simple power is that all gains are 100% tax free for a lifetime and can be used for whatever you want and taken out whenever you want.
The plan was set up to encourage people to save money. But, because it is indeed such a good deal, the “contribution room” people receive each year is limited (though what you don’t use carries forward to future years, as you’ll see below, no worries).
Again, it’s important to remember that a TFSA is a savings or investment vehicle. So, just like an RRSP, you can use it for cash savings (almost never recommended today, though), GICs, bonds, ETFs, stocks, real estate, etc. Whatever type of investment makes sense for your plan’s volatility or risk tolerance, and time horizon, can likely be used inside a TFSA.
How Does A TFSA Work?
I like to think of a TFSA as this “magical money briefcase.” What makes it magical? Two things. First, whatever investments grow inside this briefcase, the CRA can’t touch, no matter how large these investments become. And second, the amount of investments you can put into it grows every year.
So, this is how it works. You open a TFSA account (just like any other non-registered account), you invest however you see fit, all the interest and growth is yours tax free, and then you withdraw the money when you want it with no fee. It’s pretty simple!
The only part that causes some confusion is the limit on how much you can contribute per year. This is because that amount depends on not just how many years you’ve resided in Canada (since 2009), but if you’ve withdrawn funds in the current year. You see, you need a wait until the next calendar year to get that contribution room back (that is, the amount equal to what you withdrew).
How Much Can I Contribute?
Here is a chart with the annual increases for every year. Now, the CRA “Notice of Assessment” you receive every year indicates your year’s TFSA “contribution limit.” As you can see, the “dollar limit” of contribution room you have increases every year that you reside in Canada by a set amount that is indexed to increase with inflation by intervals of $500 (except for 2015 when there was a nice bump, but that’s another story). The number began as $5,000 per year. Now it’s up to $6,000, and expect it to become bigger in future years.
Here’s the only tricky part. Whatever amount you withdraw in a given year, that amount is added to how much you can contribute in the following calendar year (until you reach the cumulative contribution limit based on how many years you’ve resided in Canada since 2009). And any dollar invested over your contribution limit has a penalty of 1% of the excess contribution room every month until you withdraw it. Try to avoid that.
Whatever amount you withdraw in a given year, that amount is added to how much you can contribute in the following calendar year.
Here’s an example. It’s 2021 and you’ve lived in Canada since 2009, but haven’t opened up a TFSA before. Don’t feel bad, you just didn’t really know what it was. This means that your contribution limit this year is $75,500. So, you decide to transfer $75,500 from a non-registered investment you have into the magical TFSA briefcase because you don’t like paying more taxes than you need to. Great. You’re set for tax-free investment growth, no matter how big this $75,500 grows!
However, you’ve been saving up for a car and you need $10,000 to finance it. So, you withdraw that amount from your TFSA in April 2021. Now you need to wait until January 2022 to reinvest that $10,000 you withdrew or else you’d have to pay that 1% monthly penalty. So, in January 2022 your contribution limit will be $16,000 ($10,000 + $6,000).
The point of this “wait until the next calendar year” mechanism is to discourage you from pulling out funds too often in order to incentivize you to save for longer-term goals.
How Much Should I Contribute?
In order to answer this question properly, you need to have a long-term financial plan. If cashflow isn’t a problem, there’s virtually no reason to not max-out your TFSA. But not everyone has that kind of cash lying around. So, very commonly the question is how much to split your investing between an RRSP and a TFSA.
In such a case, you will need to look at your goals, do the math yourself or with a professional, and consider other relevant factors (e.g., group investments, US citizenship when applicable, spousal income, emergency funds and budgeting concerns, corporate assets when applicable, insurance needs, etc.). Nevertheless, here are two key guidelines to consider as you weigh how much you should put in one over the other.
- those earning less than $50,000 should prioritize TFSAs over RRSPs, and those earning more than $50,000 should prioritize RRSPs over TFSAs
- TFSA benefits are optimized for long term savings with more growth oriented investments (e.g., long-term bonds, stocks, ETFs, real estate) and largely ineffective for conservative or emergency fund accounts (e.g., cash & cash equivalents, money market funds, short term bonds).
How Do I Open a TFSA?
Canadian residents with a valid SIN (permanent or temporary) who have filed taxes in previous years with the CRA are eligible to open a TFSA. Simply reach out to an investment professional or financial institution to get started and plug it into your financial plan.
While the contribution limit is the same, there is no limit to the number of TFSA accounts you can open. So, TFSAs can easily be transferred between financial institutions, though some institutions will charge a transfer fee, and you should seek human advice and tax specialists on whether it makes the most sense to do the transfer it 1) all in kind, 2) all in cash, 3) all asset mixed, or perhaps a partial transfer for the time being.
If you don’t currently have a written, financial plan or aren’t 100% confident you’re taking advantage of TFSA benefits, then for a limited time David is offering a complimentary 10–15 financial fitness chat to answer whatever strategic questions you have for your personal situation.
Or if you desire, David makes it easy and simple to open up a TFSA or consolidate your investment funds from various institutions into one place so you can save on fees and benefit from holistic planning.
Book your session with this link, or email him at email@example.com for more details.
PS: If you just skimmed through the article, here’s the takeaway: a TFSA is an under-utilized, but extremely powerful investment vehicle that gives you tax-free interest for life in Canada. Now, it’s important to check your annual contribution limit. And given its unique benefit it makes sense, all things considered, to put your most long-term, growth oriented funds into one.
To help people do this, I’m offering a brief, 10–15 financial fitness chat to help you easily set one up, or consolidate funds from your current institution to save you on fees on maximize the benefits of holistic planning.