Tax Free Savings Account – TFSA
Much more than a savings account
Recently, I was having a glass of wine with a friend and we started talking about my new job at Kerr Financial and we got on the topic of the various types of investment accounts that exist and the benefits and drawbacks of each. When we got to Tax Free Savings Accounts (or TFSAs for short), his immediate answer was “Why bother with all the trouble of setting up a TFSA when interest rates are so low, and I’ll barely earn any interest income on my savings!”
The TFSA is not a savings account!
To my surprise, here was someone who still thought that the TFSA was essentially a savings account in which you park your cash and earn 1% per year – yes, hardly worth the effort to save a maximum of $318 in taxes assuming the current lifetime maximum contribution of $63,500 and a 50% marginal tax rate. Now for sure, some institutions are paying closer to 2% on cash in TFSAs. That would bring the maximum annual tax savings up to $635 – somewhat more interesting and perhaps worth the effort after all. I think if your financial resources are limited and you can only afford to set aside some money as an emergency fund or for saving for a specific large purchase, then you should absolutely use a TFSA as a savings account to at least save some money on taxes that you would otherwise pay in a regular savings account. Just always be careful to track your annual activity and specifically your contributions as an over-contribution can be very costly (the current maximum contribution for 2019 is $6,000 and the lifetime maximum is $63,500 as noted above).
Investments you can hold in your TFSA
The more important point that I made to my friend, however, was that the TFSA is much, MUCH more than a savings account (the federal government really should consider changing the name of the TFSA as it is quite misleading!). I asked him what kind of investments he held in his RRSP, to which he answered – I have some mutual funds, a few stocks, some ETFs (exchange-traded funds) and some cash. Well, I said, you can hold all the same types of investments in a TFSA with one of the key differences between the RRSP and the TFSA being taxation. Unlike an RRSP, the contributions to a TFSA are not tax-deductible BUT again unlike an RRSP, the withdrawals from a TFSA are completely tax-free, including all the investment income earned within the TFSA (interest income, dividends and realized capital gains).
What not to hold in your TFSA
I pointed out to him that while the list of qualified investments is quite long, there are certain types of investments that aren’t optimized when held in a TFSA such as foreign stocks as their dividends are subject to withholding taxes from the source country, which you can’t claim on your Canadian tax return because the investment returns aren’t taxable. I also noted that not all investments are qualified investments for TFSAs so when considering anything that isn’t “plain vanilla” or that is domiciled outside Canada, it’s always best to ask a qualified financial advisor as the penalties can be quite severe.
The benefit of Tax-free compounding
TFSAs are great investment vehicles for all Canadians (of course, one must be at least 18 years old to open a TFSA) due to the magic of tax-free compounding and especially for younger Canadians who want to begin saving for any long-term goal.
Assuming you invested in a balanced mix of cash, bonds and stocks and earned 5% per year, it would take only 14 years to double your money compared to using it as a savings account earning 1% (it would take 72 years to double your money!).
For any married individual with sufficient financial wealth looking to reduce his/her taxes on investment earnings and whose spouse has TFSA contribution room and is in a lower income tax bracket, he/she could gift money to the spouse and the spouse could then contribute to his/her TFSA (of course this only makes sense if the individual has already maxed out his/her TFSA).
TFSAs are also useful income-splitting and estate planning tools.
In this case, the key thing to keep in mind is that if the “gift” is ever withdrawn from the TFSA and then used to invest outside the TFSA, any investment income subsequently earned would be attributed back to the spouse who made the original gift and be taxable to him/her. For anyone wanting to pass on some of their wealth to their adult children or adult grandchildren, they could consider gifting money annually (or in a larger lump sum amount, depending on the TFSA contribution room of each child/grandchild) for the purpose of contributing to their TFSAs. This would allow the early inheritance to grow tax-free, as well as saving on probate fees.
As our conversation wrapped up, my friend said to me that we should get together for wine more often as it proved to be an inexpensive way to improve his financial literacy! I told him that what he learned was just the tip of the iceberg – there was probably a lot more he could learn about how to tax-effectively manage his finances and wealth.