Unleash the Power of Your Tax-Free Investment Account
January 1, 2019
A Tax-Free Savings Account (TFSA) is a registered account which the Ministry of Finance introduced in 2009 to encourage Canadians to save for their future income needs. While contributions are not deductible like an RRSP contribution, all future earnings and withdrawals from the plan will not be taxed.
RRSP vs. TFSA at a Glance
Who Can Open a TFSA?
Any individual who is 18 years of age or older and who has a valid social insurance number (SIN) can open a TFSA. In provinces and territories (like British Columbia) where the legal age at which an individual can enter into a contract is 19, Canadians will need to wait an extra year to open their TFSA. However, the contribution room starts accumulating as of age 18.
Every year since 2009, each Canadian over age 18 has earned the following contribution room:
A TFSA can hold any RRSP-eligible investment. This includes cash, stocks, bonds, mutual funds, EFTs, currency, Real Estate Investment Trusts (REITs), shares of private companies, annuity contracts, warrants, rights, options, royalty units, partnership units, and depository receipts.
What’s the Benefit?
No taxes are owed on investment gains earned within the plan, ever. Tax-free growth and tax-free withdrawals. Effectively, this is the most democratic form of tax relief available to Canadians.
Frequently Asked Questions
If I Can’t Contribute to my TFSA in a Given Year, Can I Carry Forward this Contribution Room?
Yes, your unused contribution room can be carried forward.
How Will I Know What my TFSA Contribution Room is for a Given Year?
Determining TFSA contribution room can be tricky as the information is only available by calling the Canada Revenue Agency (CRA) at 1-800-959-8281 or by logging into the “My Account” section of their website. Contribution room is only provided yearly as of Jan 1st.
What Happens if I Overcontribute to my TFSA?
Any overcontributed amount will be taxed at a rate of 1% per month or 12% per year.
What Happens When I Take Money Out of my TFSA?
No taxes are withheld or payable. No income slip will be issued. You lose the contribution room for that calendar year, but will regain it the following January. For instance, if you maxed out your contribution room at the start of the year, and in March withdrew $20,000, you would have no available contribution room for the remainder of the year. The following year, you would get the $20,000 contribution room back that you withdrew PLUS the new year’s allotted room.
Can I Have a Joint TFSA with my Spouse?
No, TFSA accounts can only be held individually.
Can I Contribute to my Spouse’s TFSA?
No, there is no spousal TFSA contribution method. While you can ‘gift’ the money to your spouse to contribute to their own TFSA, a word of caution here. Technically the gifted money should be protected from income attribution (attributing any gains to the contributing spouse) so long as it remains in the TFSA. However, if that amount is later withdrawn and re-invested into a non-registered account, the CRA can technically attribute the income back to the contributing spouse going forward.
Can I Have More than one TFSA Account?
Yes, you can have multiple, just be careful about overcontributing to your aggregate limit, which is not increased by having more than one account. The aggregate limit per person remains constant.
Pitfalls to Avoid
Avoid holding U.S. dividend paying securities in your TFSA
The US does not recognize the tax-exempt status of the Canadian TFSA. Therefore, they will levy a non-resident withholding tax on any dividends paid from US listed securities. This is not the case with your RRSP, which the US does recognize. When held in your non-registered account, you are able to claim a foreign tax credit. However, since the TFSA is tax-free in Canada, you won’t be able to claim that foreign tax credit. This makes the withholding tax unrecoverable. You are effectively guaranteeing a lower return rate compared to holding the same security in your RRSP or non-registered account.
Overcontributing to your TFSA
As mentioned previously, a 1% tax per month is immediately levied on any amounts you contribute above the maximum.
Avoid a TFSA if you are an American citizen
The IRS does not recognize the TFSA and views them as foreign trusts. Not only will the income be taxable, but you will significantly increase the complexity of your IRS filing. The same goes for Registered Education Savings Plans for US citizens, it is not recommended.
Trading vs. investing in your TFSA
Be careful about actively trading in your TFSA vs. buying and holding for the long term. If you are an active trader of securities with relatively short holding periods, the CRA could conclude that you are carrying on an active business within your TFSA and make all gains 100% taxable.
Be careful about swinging for the fences on that small cap stock you think could increase ten-fold. If you invest in a security that goes to zero, you effectively lose the contribution room. You do not regain that room the following year because you didn’t withdraw it.
Tips & Strategies to Unleashing the Power of Your TFSA
There is no right way to use your TFSA account. It really depends on your unique circumstances and what is most important to you. Here are some of the more common strategies and tips we employ with our clients:
Create a tax-Free source of retirement income by deferring withdrawals and maximizing compounding time.
By continuously contributing to your TFSA and avoiding early withdrawals, you are slowly converting more and more of your net worth into a tax-free source of income in later retirement. Furthermore, since withdrawals from your TFSA are not taxable, they will not impact any income tested benefits, nor be used to calculate your income should you ever need to apply to a care facility.
Let’s consider the example of a couple, aged 50, who have not opened TFSA’s yet. Between the two of them, they can presently shelter $127,000 of investments from taxation in their accounts, and continue adding every year. Assuming they contribute $63,500 into each of their accounts, and continue contributing $6,000 per person every year while achieving a 5% rate of return, their combined TFSA balance at 65 would be $522,966! Of that amount, $215,966 is from investment gains, and it’s all tax free.
If you’re worried about building an emergency source of non-taxable funds in retirement, then instead of using the TFSA, you could set up a home-equity line of credit secured against your home prior to retiring. The loan won’t be considered income if you need to use it, and should be the lowest interest rate available. Then you can assess whether it makes sense to pay off the loan using TFSA assets, or whether you prefer to leave those investments compounding tax free.
Create a tax-free legacy to your beneficiaries that avoids probate.
Similarly, to the strategy above, perhaps you don’t need the assets in your TFSA to support your lifestyle. In that case, assuming your estate plan is not complex, you could list direct beneficiaries to receive your assets upon your death. Those assets will avoid probate, pass quickly to your beneficiaries, and have no taxes owing.
Name your spouse as ‘Successor Holder’ and retain your combined contribution room.
If you have a spouse or common-law partner and would like them to receive your TFSA assets when you pass away, name them as your ‘Successor Holder’ instead of beneficiary. A spouse is the only person who can receive your TFSA assets and keep your tax-free room, even if their own TFSA is maxed.
For instance, let’s assume that both you and your spouse had contributed the maximum $63,500 to your TFSA’s, and both TFSA’s sit at approximately $80,000 due to investment growth over the years. Were your spouse to pass away and had named you as Successor Holder, you could receive their $80,000 in your own TFSA and continue to tax shelter the full $160,000. Anyone else (child, sibling, etc) receiving the $80,000 in proceeds would still receive the funds tax-free, but would not gain the deceased’s tax-free room.
The Successor Holder designation ensures a couple does not lose the combined TFSA room between them in the event one of them passes away.
Tax shelter the right investments for your situation.
According to Matt Evans, our Portfolio Manager at Westmount Wealth Group, there’s no universal answer as to what investments to hold in your TFSA.
“If we’re using the TFSA for long term tax-free compounding, I will allocate the high growth part of the portfolio to their TFSA account. High grow investments will have the most taxes payable compared to a lower yielding investment, so it makes sense to shelter those gains in the TFSA.”
“In other instances, we have clients using their TFSA as an emergency reserve that they will want the ability to withdraw from on quick notice with no tax implications. In that case, I will probably recommend we hold a portion in less volatile investments, as you want to avoid selling high growth investments during a pullback in the markets. In general, we discourage the use of TFSA’s for emergency reserve, as we feel it’s more valuable as a long-term tax shelter.”
“If our modeling shows that OAS clawback could be an issue, we may recommend any Canadian dividend paying investments be held in the TFSA as opposed to a non-registered account, because the gross-up crediting system will artificially increase taxable income, making OAS clawback more likely.”
“It’s a bit of a puzzle that needs to be worked out between the financial planner, the portfolio manager, and the client. Having an income drawdown strategy brings clarity to this process.”
TFSA contribution vs. paying down the mortgage.
There’s no right or wrong answer. From a purely quantitative perspective, you want the highest return on your money. If you can get a return rate over a 5-year period that is higher than the interest you would save on paying down your mortgage, investing in your TFSA makes more sense. After 5 years, if interest rates have dramatically increased and would be tougher to match in your TFSA, simply withdraw the funds at that point and pay down part of the mortgage.
Invest your RRSP refund in Your TFSA
If you’re in a higher tax bracket and RRSP contributions make sense for you, why not take your refund from your RRSP contribution and tax shelter it in your TFSA. What was once a tax liability is now an asset growing tax free within your TFSA. Essentially you are taking an interest-free loan on your future tax liability and investing it tax free.
The TFSA is an incredibly powerful tool that Canadians have at their disposal. It can serve many purposes, but ultimately should be driven by your financial plan and what you are looking to achieve.
Joe Basque, BA, CFP® | Financial Planner & Investment Advisor
HollisWealth® a division of Industrial Alliance Securities Inc.
This information has been prepared by Joe Basque who is an Investment Advisor for HollisWealth® and does not necessarily reflect the opinion of HollisWealth. The information contained in this blog comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
HollisWealth® is a division of Industrial Alliance Securities Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.