What is a TFSA?
Everyone loves the sound of tax-free. So, the name Tax Free Savings Account (TFSA) causes ears to perk up around Canada.
To help you make the most of your tax-free opportunities, we’ll cover TFSAs in detail with their benefits and drawbacks.
A quick overview on TFSAs
What is a TFSA? A registered savings account that protects capital gains, interest income and dividend income from taxation.
What does that mean? A TFSA is a plan where you can put qualified investments to grow. While these investments are in your TFSA, all the money earned by your investments is not taxed, even when you make a withdrawal.
How does a TFSA work? Every Canadian over the age of 18 can open a TFSA. Once opened, you put your savings into the account and invest it in a variety of investment opportunities, from very conservative to very aggressive. Then, you let it grow tax-free.
What’s a qualified investment for a TFSA?
There are a variety of investment options that you can hold in your TFSA that range from very safe to risky, including:
Guaranteed investment certificates (GICs)
Stocks/equities and bonds
Exchange-traded funds (ETFs)
What are the restrictions?
TFSAs are pretty simple investment vehicles. You invest your money and let the TFSA shelter it from taxes. Once you’ve invested your money, you are free to withdraw it whenever you want without any tax consequences or fees.
The main restriction on TFSAs is the amount of money you’re allowed to invest in a given year.
Unlike RRSPs, that limit isn’t tied to your income. In fact, when TFSAs were created, they weren't tied to anything. Instead, the federal government decided the limit each year. Since that first year, the contribution limit has been as high as $10,000 and as low as $5,500. In 2020, when the limit was $6,000 the government chose to index the limit to inflation and round to the nearest $500. That means this year (2021) the limit is $6,000. If, however, you don’t invest the maximum amount (i.e. $6,000), that excess rolls over into the next year.
So, for example, last year (2020) the investment limit was $6000. If you only invested $4000 in your TFSA in 2020, the extra $2000 would roll over to this year, leaving you with an investment limit of $8000 (this year’s limit of $6,000 + the excess $2,000 from last year = $8,000).
That rolling limit doesn’t stop after a year, either. Every year after you turn 18, your TFSA limit rolls over to the next. So, if you turned 18 before 2009 (the first year TFSAs were available) and haven’t invested a single dollar into a TFSA, your current contribution limit would be $75,500.
Keeping things straight
Here’s where it gets a little more confusing. Because TFSAs were designed to be flexible, the government allows you to pull money out and not lose any room in your TFSA. So, when you withdraw money, that amount is added back on to your investment limit in the next calendar year.
An example might make this a little clearer.
Let’s say you invested $10,000 four years ago to save up for a downpayment on a house, leaving you with $65,500 left in your contribution limit. Then, this year you withdraw that $10,000, plus all the tax-free money you made, for that downpayment. That $10,000 goes back onto your limit the next year, leaving you, once again, with the original $75,500, plus next year’s contribution amount.
That makes a TFSA a very flexible investment vehicle.
What’s a TFSA for?
Because TFSAs are so flexible, you can use them to save for just about anything. If you’re looking to purchase a new car in the next few years and want to save up for it, a TFSA gives you the perfect vehicle to earn tax-free money with your short term savings.
Many people also use their TFSAs to save for retirement, allowing them to make long-term, tax-free returns from their investment that they will be able to use to fund their retirement.
Depending on your goals, income and financial planning, a TFSA is useful for adding a tax-free boost to an array of savings opportunities.
How do TFSAs compare to RRSPs?
Both TFSAs and RRSPs are useful avenues for tax-sheltered retirement savings. For high-income earners, RRSPs are often the better choice, as you can defer your income tax when you’re in a high income tax bracket and pay when you’re in a much lower income tax bracket (i.e. after retirement). For those in a lower income bracket, or for those who have already maxed out their RRSP contributions, TFSAs may be the better option.
Pros of TFSAs
- Allows you to avoid paying taxes on investment gains
- Flexibility makes it easy to withdraw when you need to without penalties
- Rolling contribution limits allow you to contribute less and even withdraw money during leaner years without losing space in your TFSA.
Cons of TFSAs
- There are no immediate tax savings available
- There are strict penalties — like the 1% interest penalty for “over contributions”
- If you choose to withdraw money, you have to wait until next year to replace it