When it comes to saving for retirement, Canadians have a unique choice: the Tax-Free Savings Account (TFSA). TFSAs are extremely flexible, and their tax advantages can help Canadians save even more. If you want an all-purpose savings account, the TFSA could be the right choice for you.
To help you decide, let’s break down how they work and how you can open one.
What is a TFSA?
A TFSA is a registered retirement account that allows you to save and invest without paying taxes on interest or gains.
Though it’s called a “savings account,” TFSAs can hold numerous investments, including stocks, bonds, exchange-traded funds (ETFs), mutual funds, among numerous others. Canadians above 18 years old can open a TFSA, and they can withdraw money from it for any purchase, whether it’s retirement, a new car, a house, or even a vacation.
How does a TFSA work?
One of the best parts about TFSAs is their simplicity. Though they do have some rules you have to follow to avoid penalties, they’re not nearly as complicated as other financial instruments.
In sum, here’s how TFSAs work.
1. TFSAs hold different investments
Unlike simple savings accounts, which grow your money by a meagre rate, TFSAs allow you to invest in numerous securities, including stocks, bonds, real estate, ETFs, and mutual funds. Think of your TFSA as a brokerage account that allows your interest and earnings to grow tax-free.
You can also make “in-kind” contributions, which involves transferring stocks from a non-registered retirement account (read: no tax shelter) into your TFSA. Your TFSA provider will assess your stocks’ value when you make the transfer, then deduct it from your contribution room (more on that below). If your stocks are worth more than what you paid for them, you’ll pay a capital gains tax when you file your taxes for that year.
2. TFSAs have contribution limits
A brokerage account with no tax liabilities sounds amazing, but it comes with one major caveat: you can only contribute so much a year.
The Canada Revenue Agency (CRA) caps your annual contributions at a preset amount, which they call your “contribution room.” Every year the CRA will revisit the annual TFSA limit to see if they need to adjust it for inflation. For example, the maximum contribution limit for 2018 was $5,500, whereas for 2021, it increased to $6,000.
What happens if you contribute more than the annual limit?
First, the CRA will notify you that you’ve over-contributed, giving you some time to fix the funds in your account. If you don’t remove the excess, they’ll hit you with a penalty: a 1% monthly charge on your above-contribution amount.
For example, if you contributed $9,000 this year instead of $6,000, you’d pay 1% of $3,000 ($30) for every month you don’t remove the extra $3,000.
Do earnings from investments affect your contribution space?
No. Your contribution space is only affected by the amount of money you contribute directly. Capital gains, interest, and dividends don’t reduce how much space you have.
3. Contribution limits are cumulative
The moment you turn 18 years old, you start accumulating contribution space in your TFSA, whether you open an account or not. And the best part: any unused space rolls over into the next year.
For example, let’s say Maury and Rachel were both 18 years old in 2009 (the year the CRA first launched the TFSA). Maury decides to open a TFSA when he’s 18, and he contributes the maximum every year. By 2021, he would have contributed $75,500 — the maximum lifetime limit.
Now, let’s say Rachel opens a TFSA in 2021. The maximum contribution for 2021 is $6,000 for Maury, but for Rachel it’s $75,500, since she’s never made a contribution before.
Now, of course, Rachel’s contribution space is higher, because she was 18 years old in 2009. If she turned 18 in 2015, her contribution space would be significantly lower.
4. You don’t pay tax on earnings
No matter how much you earn in your TFSA, you won’t pay taxes on interest, capital gains, or dividends. Even when you withdraw money, you still won’t pay capital gains taxes on money you’ve earned.
5. You can withdraw at any time without penalty
TFSAs are extremely flexible. You can withdraw money at any time for any purchase without paying an early withdrawal penalty. You also don’t have to report TFSA withdrawals as income when you file your income taxes.
Can you recontribute money you’ve withdrawn?
Yes. You can recontribute money you’ve withdrawn from your TFSA, but you have to wait until the year after you’ve withdrawn your funds to put the same amount back in.
Let’s look at an example. Let’s say, in 2020, you had $69,500 in your TFSA (the maximum lifetime contribution space for that year). You decided to take out $15,000 to fund renovations on your home, which left $54,500 in your account.
In 2020, you wouldn’t be able to recontribute the $15,000. But come 2021, your maximum contribution limit would be $21,000 with both the $6,000 annual TFSA limit and the $15,000 you withdrew the year before.
What are the advantages of the TFSA?
You really can’t go wrong with a TFSA. As a retirement account with tax-free earnings, a TFSA can give any Canadian’s retirement planning a major boost.
1. Tax-free earnings
Yes, it bears repeating — the CRA will not tax anything you earn in a TFSA. That means if you load your TFSA with Canada’s best stocks, you can make some serious gains without paying the consequences.
2. Flexible spending
The reason they call a TFSA a “savings account” and not a retirement account is because you can use your TFSA money on anything, not just retirement. You can save money for a vacation, a new car, or a house, and your earnings would still be protected by the TFSA’s tax shelter.
3. No withdrawal penalties
Finally, unlike other retirement accounts, which penalize you for withdrawing money before a certain age, the TFSA has no withdrawal penalties, no matter how early you withdraw.
How do you open a TFSA?
It’s super simple. To open a TFSA, you need your Social Insurance Number (SIN), and you need to be the legal age, either 18 or 19 years old.
- Territories and provinces with a minimum age of 18 include Alberta, Manitoba, Ontario, Prince Edward Island, Québec, and Saskatchewan.
- Territories and provinces with a minimum age of 19 include British Columbia, New Brunswick, Newfoundland, Nova Scotia, Northwest Territories, Nunavut, and Yukon.
If you’re the legal age and you have your SIN, then contact a valid TFSA issuer (a bank, credit union, insurance company, or other financial institution) and start the process.
Can you open more than one TFSA?
You can open as many TFSAs as you like. But be careful — no matter how many TFSAs you hold, your contribution space never changes. Whether you have one TFSA or five, your annual and lifetime limits are always the same. So, if your annual TFSA limit is $6,000, and you have five TFSAs, you can contribute $6,000 across all five but no more than the annual cap.
What happens if the TFSA holder dies?
TFSAs allow you to name a beneficiary on your account, which gives that person the account value (your contributions and any earnings) after you pass away. Once your beneficiary receives the money in your account, your TFSA provider will typically close your TFSA.
Note: it’s very important to name a beneficiary on your Tax-Free Savings Account. Without one, your spouse or loved ones will have a hard time accessing the money in your account.
What’s the difference between a TFSA and an RRSP?
As unique as TFSAs are, they’re not the only tax-sheltered retirement account out there. TFSAs have a close cousin, the Registered Retirement Savings Plan (RRSP), which, depending on your situation, might be better for you. To help you decide between the two, here are some key differences.
1. More contribution space in an RRSP
For a RRSP, you can contribute 18% of your previous year’s income, up to $27,830 (for 2021). Depending on how much you make, the contribution space in an RRSP could be significantly higher.
2. Withdrawals from RRSPs are taxed
Like the TFSA, the RRSP allows your contributions to grow tax-free. But unlike the TFSA, when you withdraw money from your RRSP, you’ll pay income taxes for whatever you cash out.
Why do you pay income taxes? Well, it’s because you contribute pre-tax dollars to an RRSP, meaning you haven’t paid taxes on them yet, while the money you contribute to a TFSA is after tax. You’ve already paid income taxes on TFSA contributions, so you won’t have to pay them again.
3. RRSP contributions are tax deductible
In addition to tax-free earnings, you can deduct the amount you contribute to your RRSP from your gross annual income. This allows you to lower your taxable income, which helps you save on taxes. TFSAs, however, don’t offer tax deductions on contributions.
4. RRSPs have less-flexible withdrawals
When you withdraw from an RRSP, you must report your withdrawal as income on your tax returns. In addition, if you withdraw before you turn 71, you’ll pay a RRSP withholding tax, which can be between 10% and 31%, depending on your province and the amount you withdraw.
The only exception to the withholding tax rule is when you withdraw to pay for a house (up to $25,000) or to fund your education (up to $20,000).
5. RRSPs have an expiration date
Finally, your RRSP can’t stay an RRSP forever. By December 31 of the year you turn 71, you must convert your RRSP into a Registered Retirement Income Fund (RRIF). TFSAs, however, don’t have an expiry date.
In sum, a Tax-Free Savings Account is far more flexible. The RRSP has more contribution room but stricter withdrawal rules. At the end of the day, however, you shouldn’t choose one at the expense of the other: a solid retirement plan will include both TFSAs and RRSPs.
Should you open a Tax-Free Saving Account?
The tax advantages in a TFSA alone make these accounts worth your time and money. While you may need more than a TFSA to save for your retirement (an RRSP or non-registered retirement account), having one helps you avoid paying hefty taxes on gains, giving you more toward your golden years.
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