Ever since they were introduced, many Canadians have been taking advantage of the amazing investment vehicle that is the TFSA. The TFSA stands for Tax Free Savings Account and allows every Canadian over the age of 18 an opportunity to minimize their tax bill and collect tax free investment profits. But there are still many Canadians out there that are unsure of how they work and have a lot of questions that they want answered before they get started in opening a TFSA. In this article I will go over many of these common questions that I’ve heard or been asked over the years.
What is a TFSA?
As the name implies, the TFSA is a savings account that you can put money into and have it grow tax free. The TFSA is not an investment itself, but only a type of account that you can put investments into and allow them to grow in the form of capital gain, interest or dividends. Every investment profit inside a TFSA is tax free and does not need to be reported to the government when you file your taxes. Your financial intuition will report on your behalf how much you have contributed to your TFSA.
What can you put inside a TFSA?
A TFSA is not limited to just cash savings accounts. It can hold just about any investment, domestic or foreign. The TFSA can hold stocks, bonds, mutual funds, ETF (exchange traded funds) and options. The TFSA is basically similar to any other investment account, with the only difference being the contribution limitations and the fact that the growth is tax free.
How much can you contribute to a TFSA?
How much you can contribute to a TFSA depends on a few factors. These factors are your age, how much you’ve already contributed and how much you withdrew up to December 31st of the previous year.
The first factor is your age, you must be at least 18 to start accumulating TFSA contribution room. If you turned 18 in 2009 or earlier, you have access to the full amount, as there was no TFSA for anyone in 2008 or earlier. See the table below for a TFSA contribution room by year. The cumulative totals are shown on the right. If you turned 18 in 2010 or later, you must exclude the contribution limits from previous years.
The second factor is how much you have already contributed, this is straight forward. Even if you’ve contributed at a different bank in the past, it still counts towards your total.
The final factor is how much you have withdrawn up to the end of the last calendar year, December 31st. Once January 1st comes along, you are now able to re-add that amount back in.
- Date of Birth January 1st, 1995.
- Total contributions to TFSA = $12,000
- Total withdrawal prior to December 31st, 2016 = $3,000
- Total withdrawal during 2017 = $1,000
In this example, the person turned 18 in the year 2013. Therefore $5,500 + $5,500 + $10,000 + $5,500 = $26,500 total cumulative total. From this we subtract previous contributions and only add back withdrawals prior to the current year.
$26,500 – $12,000 + $3,000 = $17,500 total remaining TFSA contribution room.
When the TFSA was first created, the plan was to allow $5,000 per year adjusted for inflation in increments of $500. This finally occurred in 2013 when it was bumped to $5,500. Prior to the 2015 Federal elections, the Harper government increased the TFSA limit to $10,000 as part of their election platform. When the Trudeau government won the election, they reverted this back to $5,500 in 2016, honoring the previous year at $10,000 as some people had already contributed.
One final point on contribution room is that these limits apply per person, not per TFSA. You can open up as many TFSA’s as you want at different financial institutions. The limit applies to the total amount of all of your TFSAs.
TFSA over Contribute Penalties
Unfortunately, your bank won’t automatically block the transaction if you accidently over contribute to your TFSA. I must strongly advise against this as the penalties are very steep. The government imposes a penalty of 1% of the over contributed amount per month. That works out to 12% per year which is higher than the historical returns of the stock market. This is worse then being taxed, you are basically paying all your profits and more to the government. If you have accidently over contributed to your TFSA, immediately withdraw the excess amount.
What happens when money is withdrawn from a TFSA?
It is very simple to withdraw money from a TFSA. You simply need to sell the investment you are holding in it, such as the fund or stock. You then transfer the money out like any other bank account back into your normal savings account. The withdrawal space will be added back the following 1st of January. You have no tax declaration to make and no forms to fill. Its simple and easy to do and the bank will do the tracking.
How to open a TFSA?
To open a TFSA you simply need to contact your bank, or any bank operating in Canada for that matter and request to have one opened. Most banks also allow you to do this online, filling in the necessary forms as required. The process is very easy and there are no entry requirements other than being a Canadian resident who is at least 18 years old. Special note, for those who live in Newfoundland, New Brunswick, Nova Scotia, British Columbia, Northwest Territories, Yukon or Nunavut, you must wait until you are 19. However, you will start accumulating contribution room as of 18.
Recommended investments to hold in a TFSA
As the TFSA is tax free, any investment likely to generate a substantial profit is ideal to be held in the TFSA. Stocks, ETFs and mutual funds all apply here in order to avoid dividend or capital gains taxes. However, for interest generating investments such as Bonds or GICs, the payoff is even better. This is because interest is taxed at a higher rate than capital gains or dividends. However in turn, interest investments usually have a smaller rate of return than stocks or mutual funds. My preference still remains to hold the interest generating investment in the TFSA as this is a guaranteed tax savings against a potential capital gain savings.
Specifically, I’d recommend holding a diversified mix of index ETFs (Bonds and market indices). Check out my article on index investing for more information.
TFSA vs RRSP
A TFSA works the opposite way that an RRSP does (registered retirement savings plan). The TFSA does not provide any tax deferrals when you make your contributions, but allows everything being invested to come back out tax free. The RRSP provides a tax refund due to the income tax you are getting back, but then fully taxes your withdrawals as if it was employment income.
Each have their advantages, but in general the RRSP is more ideal for saving for retirement and the TFSA for all other things.