In the world of Canadian personal finance, the Tax-Free Savings Account (TFSA) is one of the most important tools that investors can use as a ‘tax shelter’ for their investments.
A wide array of financial securities can be placed within the TFSA, ranging from your conventional stocks, bonds, and Guaranteed Investment Certificates (GICs) to mutual funds, Exchange-Traded Funds (ETFs), and even cash.
According to the Canada Revenue Agency (CRA), since the introduction of the TFSA in 2009, there are now more than 20 million TFSAs in existence holding a cumulative $300+ billion, making the TFSA one of the most widely adopted savings vehicles implemented by the Government of Canada.
How does a TFSA work?
The fundamentals of a TFSA are simple.
In each year, there is a specific cap on the amount of contributions that can be made by a TFSA holder.
This cap is referred to as the annual contribution limit.
Starting from the age of 18, the annual contribution limit starts accumulating and carries over each year thereafter even if a TFSA is not opened.
For example, if a person turned 18 in Year 1 and only opened a TFSA at the end of Year 3, then the person could contribute the cumulative annual contribution limits of Year 1, Year 2, and Year 3.
Once the money is deposited into the TFSA, investors can allocate this capital into their preferred set of securities, and hopefully, watch it grow over time.
This can be done by a financial advisor for you or you can choose to go with a self directed TFSA where you complete all buy and sell transactions yourself.
An added point of flexibility that the TFSA offers is during the withdrawal process.
Investors can withdraw from the TFSA at any time without incurring any taxes on their money.
In addition, this withdrawn amount is then added to the contribution limit in the following calendar year.
However, while the TFSA offers several benefits, it is important to know the exact contribution limit in each calendar year as well as the total limit available.
Investors who over-contribute to their TFSAs in each year are liable to incur penalties at a rate of 1% of the excess contribution amount in each month until the appropriate withdrawals are made.
From its inception in 2009, the Government of Canada has set annual contribution limits in each year and the sum total of contributions that could be made from 2009 to 2023 is $88,000.
How do I withdraw from a TFSA?
There may be a multitude of reasons why people opt to withdraw money from a TFSA.
The funds could be used for an expensive life event such as a wedding or other personal reasons.
The good news is that there aren’t too many restrictions when it comes to withdrawing money from a TFSA.
To start off, there is no penalty for withdrawing money from the TFSA.
Withdrawals can be made at any time, and are not taxed.
TFSA users who withdraw money from their TFSA do not even have to report it on their tax returns for the year.
Furthermore, any withdrawals made increase the size of the contribution limit next year by an equal dollar amount.
For example, if the annual contribution limit in two consecutive given years is $5,000, and a person withdraws $2,000 in Year 1, they will then have $5,000 (Year 2 contribution limit) + $2,000 (amount of the withdrawal) = $7,000 of contribution room in Year 2.
It is also important to remember that withdrawing during the year does not give you the license to over-contribute to the TFSA.
At the beginning of each year, the Government sets a fixed contribution limit.
Even if funds are withdrawn during the year, they do not increase the contribution room until the next year rolls around.
This is an important caveat to remember as the penalties for over-contribution can get pretty hefty, as mentioned above.
Who is eligible for a TFSA?
To put it simply, any Canadian resident who possesses a valid Social Insurance Number (SIN) and is 18 years of age or older is eligible to open a TFSA.
According to the CRA, any non-resident Canadian individual with a valid SIN above 18 years of age can also open a TFSA.
However, any contributions made by a non-resident are subject to a 1% tax for each month that the contribution remains in the account.
Pros of a TFSA
Now that we have a good overview of what the TFSA is and how it works, it is useful to evaluate whether it is the right investment tool for individual savers.
Note that each saver’s financial profile and requirements may be entirely different, so there really is no common approach that can be followed or uniform decision methodology that can be applied.
Notwithstanding, here are some of the main advantages of using a TFSA.
Tax-free investment growth
The power of compound interest has been well-documented by famed investors such as Warren Buffett and Peter Lynch.
However, investment growth in most scenarios is subject to capital gains taxes, amongst other types of taxation.
In a TFSA, however, growth occurs on a tax-free basis.
To illustrate the impact of this growth, an investor who puts $5,000 into a TFSA each year for 30 years and earns an average of 5% will have $353,804 at the end of 30 years.
The excess return they have made i.e. [$353,804 – ($5,000 x 30 years)] = $203,804 is then tax-free.
Life is unpredictable, and at certain times, people may need access to funds on short notice to pay for an unforeseen expense.
In these scenarios, the flexibility of the TFSA is a tremendous benefit as withdrawals can be made at any time without paying any withholding tax.
Contribution room remains the same for all
The contribution limit for a TFSA is centrally mandated by the Government of Canada and remains identical for people across the country – regardless of their level of income.
That means that TFSA users who are in a lower income bracket can shelter a higher percentage of their income from tax.
As a reminder, note that the contribution limit for 2023 is $6,500.
Contribution limit remains fixed
Even if a withdrawal is made during one calendar year, the contribution room for the next year increases by an equivalent amount of the withdrawal.
That means that the only downside to withdrawing funds is the opportunity cost of missing the tax-free growth from the time the money was withdrawn to the time it is put back into the TFSA in the following calendar year.
Assets in the TFSA can be transferred to children or next of kin at the time of death without being taxed as the TFSA is a tax-free vehicle.
Cons of a TFSA
Despite the strong merits of a TFSA, there are also some factors to consider for individuals and households as below:
The flexible withdrawal process can be both a blessing and a curse.
As a result of no penalties being charged and withdrawals remaining free from tax, a lack of discipline can lead to frequent withdrawals which defeats the purpose of allowing capital to compound tax-free while inside the TFSA.
No benefit to taxable income
Unlike the RRSP, the TFSA cannot be used to lower taxable income in any given year.
This makes maxing out the RRSP first a more appealing option, particularly for high-income earners.
No creditor protection
In a bankruptcy situation or in a scenario where the TFSA user is involved in a lawsuit where he or she has to pay damages to the aggrieved party, the TFSA can be confiscated by creditors to make the requisite payments.
Conversely, RRSPs are protected from creditors.
In the event of bankruptcy or other such scenario described above, RRSPs cannot be confiscated.
Day trading is not allowed
Day trading is defined as a form of trading where the trader buys and sells a financial security within a short period of time (usually within the same trading day).
Because the Government is looking to incentivize long-term investment income over short-term gains, day trading is not allowed in a TFSA.
When assessing whether a user is engaging in day trading, the CRA will look at several factors including the duration of the holding, type of investment, trading volume, and total time spent trading to evaluate whether an activity counts as day trading or not.
The information above is designed to give an individual a flavour of what to expect and how to make a rational decision when evaluating a TFSA.
Before opening a TFSA though, it may be worth approaching a specialist financial advisor who can guide you on whether a TFSA is truly aligned with your long-term preferences and goals.