Investing 101: What is a TFSA?
Updated: Feb 10, 2021
So what is a TFSA?
Planning for your financial future can be confusing. You are presented with numerous investment types and account options. So how do you choose the best fit for you? This article explores tax-free savings accounts and how you can use them to reach your financial goals.
Canadians can invest their savings into several types of accounts. The two main types are registered and non-registered accounts.
Non-registered investment accounts
Non-registered accounts are not registered with CRA and do not enjoy the same tax advantages as registered savings and investment accounts. There are no limits as to how much money you can contribute to these accounts each year. Earnings within non-registered accounts are subject to tax, reducing your annual rate-of-return.
Registered investment accounts
Registered savings accounts are where Canadians hold the majority of their investment savings. These accounts are registered with CRA and afford the account holder tax privileges. Investment earnings on funds held within registered accounts are not subject to taxation the same way non-registered accounts are.
There are two types of registered savings and investment accounts in Canada. There are registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs). This article will define what a tax-free savings account is and who is best suited for this type of account.
If you want to find out more about RRSPs check out this blog article.
What is a TFSA?
A TFSA savings account is similar to an RRSP in that its holdings are not taxable while held within the account. There are maximum contribution limits and penalties for over-contribution within a tax year.
Though your earnings within a tax-free savings account are not taxable, your contributions are not tax-deductible like they are for RRSPs. Also, unlike an RRSP, your withdrawals have the benefit of not being subject to withholding tax. Since there is no withholding tax on TFSA accounts, you can withdraw this money out at any time without penalty.
What types of investments can a TFSA hold?
Your TFSA savings account can hold any of the following qualified investments:
Securities listed on a designated stock exchange
Shares of certain small businesses and corporations (must be arms length investments)
What types of investments are prohibited in a TFSA?
You cannot hold any investments that aren't made at arm's-length in a TFSA savings account. An arm's-length investment is an investment made to anyone who is a related family member or benefits directly from the investment. For example, a mortgage lent to a sibling would not be considered arms-length and therefore could not be held within a TFSA savings account.
Who can Open a TFSA?
Any Canadian resident 18 years or older may open a tax-free savings account. There is no maximum age for opening or contributing to a TFSA and no income requirement. If you are a non-resident for tax purposes, investments held within a TFSA can be taxed at 1% per month! Speak to your tax or financial advisor to determine whether you are eligible to open a TFSA account.
Just as with an RRSP, there are annual contribution limits that apply to TFSAs. You cannot lose your contribution room, so if you have unused room from prior years, it will be carried forward allowing you to deposit up to the combined limit of this and all prior years.
How many TFSA savings accounts can you open?
You may open as many TFSA savings accounts as your financial institution allows. The only caveat is that you can only contribute up to the defined maximum as per the CRA contribution limits. These limits apply across all accounts.
For example, for 2020, the maximum TFSA contribution limit is $6,000. If you have three separate TFSA accounts, you can deposit $2,000 per account; or $5,000 in one account and $500 into the other two etc… so long as you don’t exceed the maximum amount for the year.
Some of the best mobile investment apps like Moka allow you to open up an unlimited amount of tax-free savings accounts. This ability allows you to set up TFSAs for specific goals. You may have one account you use for retirement planning, one for saving for a down payment on a house and another for saving for last-minute travel.
Tax Benefits of Investing in a TFSA
Taxation can reduce the earnings on investment. In a typical non-registered investment account, any interest, dividends and capital gain is exempt from taxation. Tax exemption ensures that you can continue compounding the returns on all of your investment earnings.
This benefit becomes more pronounced the higher your nominal tax rate is.
For example if your income is $100,000, your nominal tax rate is 37.16% (in Ontario). Earning an additional $10,000 in interest in that year, you will owe $3,716 in tax, reducing the capital available for investment to $6,284. If you are earning a 7% return on your investments, your following year’s ROI is reduced by $260.99 plus the tax payable ($3,879) for a total reduction of $4,140 versus earning the same $10,000 in a tax-free savings account.
Withdrawing from TFSAs
Aside from the tax benefits of investing in a TFSA, there are benefits for investing in a TFSA versus RRSP. This benefit is due to the rule on withdrawals from tax-free savings accounts. When withdrawing from your RRSP, the withdrawal is added to your taxable income for that year. Even though your investment returns have grown tax-free, you will now have to pay tax as you withdraw them, reducing the amount of money available to you.
With a tax-free savings account, you can withdraw your money without paying tax on the additional income. This benefit occurs since you have already paid tax on contributions to your TFSA. With a TFSA, you’re unable to deduct your contributions from your taxable income and therefore fund these accounts with after-tax earnings.
Who is a TFSA for?
Tax-free savings accounts are suited for many types of investors. To determine if a TFSA is right for you, here are some considerations you should consider:
Short timeframe - If you expect to hold funds in these accounts for short periods for purposes other than saving for a down payment on a house, a TFSA will be more suitable than an RRSP
High-income earner - If you are already contributing your annual maximum to your RRSP, take advantage of the additional tax benefits of investing in a TFSA savings account. Find out more about RRSP contribution limits with this article
Flexibility - Life happens and sometimes we need access to retirement funds earlier than expected. With RRSPs this can have a major impact on taxation as accessing them before retirement will likely increase your tax bracket and taxes paid. Since there is no taxation on TFSA withdrawals, these accounts make the most sense for planning for emergencies
TFSA savings accounts are excellent ways to grow your money tax-efficiently. They provide excellent savings vehicles while allowing the flexibility required for shorter-term needs. Whether you’re saving money for a down payment on a house or your retirement, tax-free savings accounts should make up a portion of your investment strategy.