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Finance

What the heck is a TFSA?


Photo by Joseph Gruenthal from Unsplash

One of the side-effects of working for a personal finance magazine is that my buds good-naturedly ask me for advice. I always oblige, albeit sheepishly, without letting on that I’m still learning, too (which I freely admit here).For instance, the other day I was having lunch with some friends when we started talking about money. The exchange went something like this:

Friend: Ugh, I’m so lost when it comes to money. What should I do?

One of the greatest mistakes young people can make right now (other than blow their money on something stupid, like, say, a house in Toronto) is not realize that their money can do more than just sit there.

Me: Well, do you have a TFSA?

Friend: Yes (in a proud voice).

Me: That’s great, you’re ahead of the game. What are you investing in?

Friend: W-w-what?

I then went on to explain what a TFSA really is. The tax-free savings account is NOT, I repeat, NOT just a savings account.

What is a TFSA?

A tax-free savings account (TFSA) should really be called a tax-free INVESTMENT account. That’s because it is a registered account that allows you to hold not only savings, but also equities like stocks, mutual funds, GICs, bonds and ETFs. Inside a TFSA, all of your investments grow tax-free. Another bonus? Unlike with a Registered Retirement Savings Account (RRSP), when you withdraw funds from your TFSA, you aren’t on the hook for taxes. That’s right: You don’t pay taxes on the growth inside your TFSA, and you don’t pay taxes when you take your money out of it.

Who can open a TFSA?

Any Canadian over the age of 18 who has a valid social insurance number (SIN) is eligible to save or invest in a TFSA.

How do TFSA contributions work?

If you’re asking, “What’s the catch”—well, there isn’t one, unless you count the yearly limit for the amount of money you can deposit into the TFSA. Each year, the federal government announces what the annual maximum contribution is; for 2020, it’s $6,000. If you miss a year, or don’t make the maximum contribution, your unused contribution room can be rolled over into future years. So, if you turned 18 before 2009, the first year TFSAs were made available, your current lifetime maximum contribution room is $69,500. When you withdraw money from your TFSA, that exact amount becomes available to you to contribute again as of the next calendar year. So, let’s say you withdraw $4,000 this year to fund a minor home renovation; in 2021, you’ll be able to contribute that year’s announced maximum, plus the $4,000 you withdrew in 2020. (For a more precise look at how much you can contribute, enter your digits into our TFSA contribution room calculator.)

Can I have multiple TFSA accounts?

There is no limit to the number of TFSA accounts one person can have, but your total contribution limit remains the same. So your annual contribution limit (as of 2020) is $6,000, whether you have one TFSA or six. (The lifetime maximum for those who were 18 or older as of 2009, is $69,500.) The more accounts you have, the harder it is to keep track of them; there are penalties for over-contribution, so you’ll want to ensure you don’t exceed your annual or lifetime limit at any time.

What can I invest in with a TFSA?

You can hold the following qualified investments within a TFSA:

Savings accounts 

These are the safest vehicles for investing your money. Since savings accounts are essentially no-risk investments, because they are insured by the CDIC or similar provincial bodies (check the details with your financial institution), even high-interest savings accounts pay a very low rate of return compared to other investments. 

Guaranteed investment certificates (GICs)

GICs are very safe, low-risk forms of investment with returns that are normally subject to tax at your marginal income tax rate unless they are held within a TFSA. GICs guarantee a rate of return for a fixed period of time, such as a one-year or five-year term. Non-redeemable GICs pay a higher rate of return in exchange for tying your money up for the entire term. If you think you might need to access your money before the end of the term, you can choose to hold cashable/redeemable GICs, which allow you to withdraw some or all of your investment at any time—but know that you’ll earn a lower rate of return with these types of GICs, and all GICs pay a lower rate of return compared to other investments.

Stocks/equities and bonds

Investing in the stock market has the potential to pay a sizeable return on a small investment. However, stocks and bonds are also subject to a high degree of risk. While they can be held within a TFSA, they require both a higher financial aptitude and a higher risk tolerance than other investment options.

Exchange-traded funds (ETFs)

An ETF is a basket of investments that’s usually pegged to follow a particular market index. They can be a mix of different stocks, bonds, commodities or all of the above. They are bought and sold on an exchange, so you need a brokerage account to trade them individually, but they also work well as a complement to automated robo-advisors, such as Wealthsimple or Questwealth, since they are designed to be fairly hands-off. ETFs pay a moderate return for a moderate risk, and because they are not actively managed, they come with relatively low fees. Since ETFs do track the stock market as a whole, they are subject to the volatilities of the market and are better used as long-term investment tools, so your portfolio has a chance to rebound from any losses. 

Mutual funds

Similar to ETFs, these popular investment funds are diverse collections of stocks, bonds and commodities. However, rather than passively following the market or a particular index, mutual funds are actively managed by a portfolio manager, through your financial institution or by a robo-advisor. Because mutual funds are actively managed, they generally carry higher fees than stocks, or passively managed investments such as ETFs; it’s important to pay attention to returns after fees when you are deciding which funds to invest in. The degree of risk and potential return varies with the mix of assets held inside the fund. Like all investments held within a TFSA, earnings on mutual funds will not be taxed. There are many funds to choose from, depending on your risk tolerance, and they can be a sound hands-off option for long-term investments. 

Compare the Best TFSA Rates in Canada*

What should I use my TFSA for?

The great thing about TFSAs that’s particularly helpful for young people with shorter-term savings goals is that you can withdraw the money at any time without getting dinged or taxed or levied in any way. Pretty sweet.

I opened up a TFSA in high school at the behest of my father. Growing up, we’d seen financial hardship and he didn’t want me to have the late savings start that he did when he came to Canada in his mid-30s, family in tow. I bought some mutual funds and contributed $25, then $50 a month from my meagre part-time-job paycheques. I can’t say I paid much attention or really cared about the growth I was seeing. But I felt good knowing that I was doing something. And it was comforting in my panic in university when I was certain I would graduate, then be unemployed and have no income.

I was lucky to have my father instil the importance of growing my money at that age, so I was aware of the investing powers of the tax-free SAVINGS account.

If you’re a newbie (like me) and this is new information to you, go forth and buy some investments! Your TFSA could be growing your money, not just hoarding it for safekeeping.

TFSAs vs RRSPs: the basics

Both TFSAs and RRSPs are long-term savings vehicles for Canadians, which offer some tax protection. With TFSAs, you pay income tax on the money you invest when you earn it, but do not pay taxes on the returns that accrue within or the TFSA, not even when you withdraw it. In contrast, the earnings on RRSP investments are tax-deferred in the year that you earn and contribute, but subject to income tax when it is withdrawn as retirement income. RRSPs are a good choice for high-income earners who expect their retirement income—and, thus, the tax they end up paying—to be lower than their current income. For others, TFSAs are a better choice.

What are the benefits of a TFSA?

  • Tax-exempt earnings on investments. These can amount to significant savings over the long term.
  • Flexible withdrawal options. You can take out as much as you want, whenever you want, without penalty.
  • Rolling contribution limits. As long as you have a TFSA in your name, you won’t be penalized for lean years when you contribute less or even withdraw funds. That amount will simply accrue for you to invest in the future.

What are the drawbacks of a TFSA?

  • No immediate tax deductions for contributing. If you are in a high tax bracket and trying to mitigate your tax bill in any given year, an RRSP may be a better choice.
  • Strict penalties for over-contributions. Even if you accidentally exceed your annual contribution limit you will be subject to a monthly 1% interest penalty. 
  • If you withdraw funds from a TFSA, you have to wait until the following year to replace that money.

MORE ABOUT TFSAs:

Watch: The differences between a TFSA and RRSP

This article was originally published on June 4, 2020. The video was added on Oct. 28, 2022.



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