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Let’s start with what they’re not for: parking cash and looking for interest. It seems, because of the misleading name of the TFSA, tax-free savings account, that many people think it is an account best used to save money and accrue interest. While some banks will provide a high(ish) interest rate for cash in a TFSA, the reality is that this is far less than even a conservative investment in an ETF or mutual fund. Keep Reading
What is the TFSA?
The Tax Free Savings Account is a savings and investment tool that was designed to help encourage savings by way of tax-free capital gains. The name can be somewhat misleading in that when you deposit money into your TFSA, these contributions are not deductible against your income tax the way that an RRSP is. Instead, the TFSA is beneficially used as an investment vehicle where you purchase and sell investments such as mutual funds, ETFs or stocks, (learn more about mutual fund and ETFs here), because the capital gains you make on those investments are tax-free within the TFSA.
Hang on, what is capital gains tax and how much of my investment gains does it take if I don’t use a TFSA??
In Canada, capital gains tax is applied to half of your capital gains, at your marginal (highest) tax rate. This means that say for example if I make a capital gain of $20,000 CAD on investments, then $10,000 of those gains are taxed at my marginal tax rate. If I earn 75k per year, then my marginal tax rate is 20.5% (find your tax rates here), and thus $10,000 of my gains are taxed at 20.5%, equalling $2,050 due in taxes. Alternatively, if it’s simpler, you may also view it as the full capital gains being taxed at half your marginal rate: $20,000 x 10.25% = $2,050 due in taxes. Different equation, same result. With a TFSA, no capital gains tax apply.
Is a TFSA like an RRSP?
Both are savings accounts, but unlike an RRSP (registered retirement savings plan), where taxes do apply once money is withdrawn (with certain exceptions like purchasing your first home), when money is withdrawn from your TFSA, taxes are not applied. The idea with an RRSP, and the reason that it has the word “retirement” in it, is that you contribute savings during your working life, receive tax deductions against your current income tax (much higher now than at retirement), and then when the money is withdrawn as a retired senior, you pay only a minimal amount of tax on withdrawals. These withdrawals are treated as retirement income and come with a rate significantly less than your tax rate as a working citizen. This is the government’s way of incentivizing Canadians to save for retirement = less financial burden on the government.
Can I put as much money as I want into my TFSA?
Unfortunately, no. The government regulates each year the level of contributions eligible for your TFSA, and it varies greatly depending on the government and their federal budget. In 2015 the Conservative government raised the maximum annual contribution to $10,000 CAD – which was great news for Canadians. This year, the new Liberal government has reduced the maximum annual contribution to only $5,500 CAD.
What does annual contribution mean?
It means that each year you are allowed to contribute a maximum amount of money into your TFSA.
If I deposit money and then withdraw, how does that affect my limit?
Regardless of whether or not you deposit and then withdraw money, every contribution counts towards your maximum, or limit. So if I deposit $2,000 in March, and then $1500 in July, but then need some of that cash for a trip and withdraw $2500, I have contributed $3,500 of my $5,500 annual contribution. Even though I withdrew some of my money, the contribution still counts and I only have $2,000 in contribution space left.
What happens if I only contribute some of my limit one year?
Then, kindly, the space you had left is rolled over to the next year. Using that last example, if I didn’t use up that $2,000 in contribution space, I could roll it over, or carry it forward, to the next year and I would now have $7,500 in contribution room (Year 2016 leftover contribution space $2,000 + Year 2017 annual contribution $5,500 = Year 2017 total contribution space $7,500).
How do I use it?
Rather simply. First of all, you can set up a TFSA pretty much anywhere, and you can have many of them. If you have a broker who invests for you, he or she can set up your investment in a TFSA at their brokerage. If you have a financial advisor at your bank, they can also set one up for you and this is where they will purchase investments on your behalf like an ETF so that any gains made are subject to zero capital gains tax, as explained above. You may also hold cash in your TFSA, though the interest rates are not particularly different than a regular savings account and TFSA cash savings are not eligible for any special treatment so it’s not doing much for you.
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