Understanding TFSAs: The basics
One in three Canadians still wonder, what exactly is a TSFA?
Of all the saving and investment options available to Canadians, the TFSA (Tax-Free Savings Account) might be the least understood. (A BMO study in December 2013 found that more than one-third of Canadians don’t really grasp how TFSAs work.) So if you’re not 100% clear, you’re not alone. Take just a few minutes to read up on TFSA basics: you’ll easily see how you could reap the potential rewards of this little financial gem.
Of course, this is just the tip of the iceberg of understanding TFSAs; if you have further questions, be sure to consult with an advisor.
Let’s start with the fundamentals:
Introduced in 2009, a TFSA is a type of registered savings plan in which any investment income you earn is tax-free. The amount invested inside your TFSA can be withdrawn, also tax-free.** (When you can withdraw funds will be determined by the terms of your investment.) Anyone 18 years of age or older and a Canadian resident with a valid Social Insurance Number (SIN) can open a TFSA. However, if you’re in a province or territory where the age of majority is 19, you may need to wait an extra year before you can open a TFSA though your contribution room will carry over from when you were 18.
What’s the difference between an RRSP and a TFSA?
Think of it like this: with an RRSP (Registered Retirement Savings Plan), you don’t pay tax on money that goes in, but you do pay tax on money that comes out. With a TFSA, it’s the opposite. You’ve already paid tax on the money you put into it, which means you don’t pay tax when you make a withdrawal.
Therefore, a TFSA is a great option when you want to withdraw funds. Here’s another example: if you plan to take out money before retirement, a TFSA will let you do that. Another difference is that, unlike an RRSP, you can keep contributing as long as you live, with no need to collapse it at a set age.
What else do you need to know about TFSAs?
Don’t let the “tax-free” part in Tax-Free Savings Account confuse you
Unlike an RRSP, the money you put into a TFSA doesn’t reduce your taxable income (to potentially put you in a lower tax bracket). For instance, if you make $50,000 this year, and you decide to put $10,000 into a TFSA, your taxable income doesn’t become $40,000. This is a common misunderstanding.
Don’t let the “savings” part in Tax-Free Savings Account limit you
Although the TFSA is a type of registered savings plan, there’s so much more to it than just a savings account; the TFSA is so adaptable, in fact, the letter F in the name might as well stand for Flexible. If you’re looking to invest in your TFSA for the short term – to buy a car, let’s say – a TFSA may be a good choice. And if you’re looking to invest for the long term in your TFSA – for example, to buy a vacation home down the line – a TFSA can help you with that too.
Where are you in life? And how can a TFSA help?
I’m just starting out.
If you’re a young investor, you’re likely hoping to pay down your student loans, plan for a wedding, or save for a down payment on your first home. Because your earnings in a TFSA are tax-free**, your savings grow faster. The benefit: you can withdraw money without tax consequences whenever you need to, and recontribute later in the same year if you like (if you still have contribution room remaining).
I’m comfortably settled into life.
At this point in life, the future is what matters. You may be saving up for your retirement (especially if your RRSP contributions have been maxed out), or maybe a well-deserved vacation or home renovation. A TFSA can be used however you wish, any time you wish – and remember, all potential returns are tax-free.**
I’m happily retired.
Congratulations! A TFSA could be just what you’re looking for to reinvest your mandatory Register Retirement Income Fund (RRIF) withdrawals or any other income you may be receiving in retirement. A TFSA is also worth considering when looking to leave a legacy for your children or grandchildren.
TFSAs are a versatile way to invest
A TFSA can hold a wide range of investment vehicles. It all depends on your income, goals and tolerance for risk. For example, you can hold mutual funds, stocks, ETFs (exchange traded funds) and fixed income in your TFSA. You can also hold GICs (Guaranteed Investment Certificates) and cash in a TFSA, but those may have a lower yield potential than the first four.
TFSA tips, tricks and good-to-know info:
The contribution limit vs. contribution room
The annual TFSA contribution (dollar) limit for 2017 is $5,500. If you don’t contribute the full $5,500, this leaves unused contribution room that accumulates annually (as it does with an RRSP). This means you can contribute more than the annual TFSA dollar limit each year, as long as you didn’t contribute the maximum in past years. Check your previous year’s tax return to see how much unused contribution room you may have.
Money for an emergency
We’ve mentioned this before but we can’t stress it enough: the TFSA is flexible. In many cases, funds are available in next to no time, and you don’t pay taxes on those withdrawals (like you would on a withdrawal from an RRSP). Withdrawn funds will also buy you more contribution room the following year.
The high-interest rate savings account vs. a TFSA
The most obvious difference between the two is that you pay taxes on any income you earn within a regular high-interest rate savings account, whereas in a TFSA you don’t. You may want to consider putting money from any non-sheltered accounts into a TFSA as part of your overall investment strategy. Again, this might be something to discuss with an advisor.
You can use your TFSA as loan collateral
Yes, it’s a little known fact but it’s true. You can use the assets inside your TFSA as collateral for a loan (whereas you can’t with an RRSP). This can come in handy if, for example, you have money tied up in your TFSA inside a locked-in GIC: you can’t unlock it, but you can use it as collateral.
How a TFSA affects capital gains and losses
If you earn capital gains on stocks, ETFs or mutual funds held outside a TFSA, you could be taxed on 50% of the total gain. However, if you hold those investments in a TFSA, any capital gains you earn are tax-free.** Capital losses, on the other hand, cannot be claimed if they occur inside a TFSA.
TFSA withdrawals don’t affect government benefits and credits
When you take money from a TFSA, it doesn’t count as income. That means you don’t pay tax on it, it doesn’t affect your GST credit or Employment Insurance, and you won’t suffer clawbacks on your Guaranteed Income Supplement or Old Age Security.
Over-contributions: Be sure to know the rules
If you withdraw money out of your TFSA, you can recontribute it, but only if you have contribution room available. If not, you will have to wait until the next calendar year. If you contribute during the same year and surpass your limit, you’ll be subject to a tax each month on the amount of the over-contribution.
Let’s look at an example. Kristina opened her TFSA in 2011; she’s contributed the maximum dollar limit every year since. That gives Kristina a total of $36,500 in her TFSA account by the end of 2016. When 2017 comes, she contributes $5,500, the top dollar limit for that year. Suddenly, Kristina sees the opportunity for the trip of a lifetime, so she withdraws $3,000 to travel. Then, just as suddenly, she discovers she can’t go.
She simply can’t put that money back into her TFSA. Because she’s already maxed out her TFSA contribution for 2017, Kristina will need to wait until the beginning of 2018 to recontribute all or part of the $3,000 she withdrew (which will be added to her TFSA contribution room at the beginning of 2018). If she goes ahead and recontributes before that, she’ll have an excess amount in her TFSA. That means she’ll be charged a tax equal to one per cent of the highest excess TFSA amount for each month that excess remains in her TFSA.
This blog post is for informational purposes only and is not and should not be construed as, professional advice to any individual. Individuals should contact their BMO representative for professional advice regarding their personal circumstances and/or financial position. The information contained in this report is based on material believed to be reliable, but BMO Financial Group cannot guarantee the information is accurate or complete. BMO Financial Group does not undertake to advise individuals as to a change in the information provided. All rights are reserved. No part of this report may be reproduced in any form, or referred to in any other publication, without the express written permission of BMO Financial Group. ®/™ Registered trade-marks/trade-marks of Bank of Montreal, used under license.