A Guide to the TFSA
The Tax-Free Savings Account was introduced in 2009 by the Government of Canada to help Canadians save money. Like other registered accounts, such as the RRSP or RESP, the TFSA is a tax-sheltered way to grow your wealth. It is the most powerful tax-advantaged savings vehicle available to Canadians, but many of us aren’t using it to its full advantage!
How the TFSA Works
The TFSA is an all-purpose account. Unlike other registered accounts that are dedicated to specific purposes, like saving for retirement or post-secondary education, you can spend the money inside your TFSA whenever and however you want.
As the name implies, all forms of income—meaning any interest, dividends, or capital gains—earned from investments within the Tax-Free Savings Account aren’t taxed. Despite the name including the term “savings account”, your TFSA is actually a powerful investment tool. You can open a variety of different investment vehicles under the TFSA umbrella, including mutual funds, GICs, robo-advisor, or self-directed brokerage account. Since these typically offer a higher return than traditional savings accounts, investing in your TFSA is the best way to maximize its tax-advantaged power.
Contributing to Your TFSA
There are two contribution limits you need to keep your eye on when it comes to contributing to your TFSA: the annual contribution limit and your lifetime contribution limit. If you over-contribute to your TFSA, you will need to pay a fee of 1% of the over-contribution amount per month until you withdraw it. The CRA does monitor your TFSA contributions and withdrawals, so they will enforce the over contribution penalty if you put too much money in your TFSA.
Annual Contribution Limit
Everyone over the age of 18 receives the same amount of annual TFSA contribution room each year. The amount has ranged from $5,000 in 2009 to as high as $10,000 in 2015. For 2019, the annual contribution limit is $6,000. You can view a full history of the contribution limits for each year since the inception of the TFSA on the Government of Canada’s website. Knowing the historical annual contribution limits since you turned 18 is important for calculating your lifetime contribution limit!
Lifetime Contribution Limit
You are entitled to all the TFSA contribution room that has accumulated since you turned 18. In other words, if you turned 18 before this year and are opening a TFSA for the first time, you can contribute more to your TFSA than this year’s annual contribution limit in order to “catch up” on the years you missed. Likewise, if you make a withdrawal from your TFSA, you get that contribution room back the following year.
For example, let’s say you are 21 years old and have never opened a TFSA. You turned 18 in 2016, which means you’re entitled to the combined contribution room for 2016, 2017, 2018 and 2019 were $5,500 each, adding up to a total lifetime TFSA contribution limit of $22,500. Because you have not used a TFSA before, you could contribute this amount without penalty in 2019.
The current lifetime contribution room of the TFSA in 2019 is $63,500 for anyone who was age 18 or older in 2009. However, because the TFSA allows for your investments to grow tax free, it is possible for people to have many thousands of dollars more than $63,500 in their TFSA thanks to interest, dividends, and capital gains.
Withdrawing from Your TFSA
Withdrawing from your TFSA is as easy as contributing to it: You simply take the money out. You do not have to fill out any forms or make any special arrangements to withdraw from your TFSA. However, you do have to be conscious of how your withdrawals affect your contribution limits that same year.
When you make a withdrawal from your TFSA, you do not get that contribution room back until the following calendar year. For example, if your TFSA is maxed out and you withdraw $2,000 in June to go on a vacation, you cannot make any further contributions to your TFSA until January 1. At that point, your $2,000 withdrawal will be returned to you as additional contribution room for that year.
Because the investment gains within your TFSA are tax-free, they are also not counted as taxable income and become part of the contribution room you accrue when you make a withdrawal. For example, if you invested $5,000 into your TFSA brokerage account and earned $250 in capital gains, you’d have $5,250 in your TFSA. You could withdraw this full $5,250 completely tax-free. You would then get $5,250 added back to your contribution room the following calendar year.
The TFSA vs. the RRSP
Many people feel overwhelmed by the number of options they have to save for their future, and choosing between the TFSA or the RRSP has led to many a headache. Ideally, you should have both a TFSA and an RRSP, but if you must choose, the TFSA is usually the winner.
The reason the TFSA is more powerful than the RRSP is simply because tax-free income is always better than tax-deferred income. While the RRSP is a fantastic long-term wealth-building tool, income earned from an RRSP in the form of interest, dividends, and capital gains will eventually be subject to income taxes when you make a withdrawal in retirement.
How to Make the Most of Your TFSA
Your Tax-Free Savings Account is best used to set money aside for retirement. While you may be tempted to use your TFSA for things like saving for a vacation, it’s a waste of the account’s potential. Furthermore, your TFSA works best as an investment account and not a savings account, so I advise those who open a TFSA to set it up with a robo-advisor or self-directed brokerage. Finally, be very mindful of your annual and lifetime contribution limits so you don’t go over. You don’t want to spend any of that tax-free income on fees!