TFSA, RRSP WTF? – What is a Tax-free savings account and how does it work
When the Tax-Free Savings Account was launched in 2009 there was a great deal of confusion on exactly what it was, how it worked and how best to use it. 5 years later and the majority of people that I meet are still surprised when I explain how a TFSA works and its benefits. I will cover the common questions that I get from people and what to be careful of when using a TFSA in your financial planning.
Who can open one?
A Canadian resident age 18 and if you have a valid social insurance number you can open a tax-free account. There is no maximum age by which the TFSA must be collapsed, so even your great-grand parents can open one. The account can stay open throughout your entire life or can be withdrawn and used for any purpose at any time.
The TFSA can only be registered in one individuals name so no joint or spousal accounts are available. Depending on your province the account is open, you can designate a beneficiary who will receive the funds in the account should you pass away tax-free. There are no limits to how many TFSA accounts you have open however, you cannot go over the annual contribution room available to you.
What can you put in it and how much?
This is the biggest misunderstanding I see with the TFSA, everyone is under the impression that you can only keep cash in it. The same investments that you have in a RRSP/RRIF/RESP you can have in a TFSA. This includes guaranteed investment certificates (GICs), mutual funds, bonds and securities listed on a designated stock exchange.
Since 2009, the limit has been fixed at $5,000. TFSA contribution room limit is increasing to $5500 for 2013 and it accumulates each year once you turn 18. Unused contribution room for a given year is not lost but rather, it is carried forward to the following year. So if you have never contributed to a TFSA until this year you have a limit of $5000 + $5000 + $5000 + $5000 + $5500 = $25 500. That is $25 500 of investments growing tax free!
Plus any eligible withdrawals from a TFSA in a given year are added to the contribution room at the beginning of the following year. So if baby needs some new shoes and you take $1000 out in 2012, $1000 will be added to your 2013 contribution limit to make it $65500. You do not lose your contribution room and after an eligible withdrawal, you can in fact restore room that has already been previously used.
What if you put too much in one year?
Your annual contribution room is reported on your Notice of Assessment issued by the CRA. An over contribution will result in a penalty tax calculated monthly and based on 1% of the highest excess amount each month the situation applies
What do I use it for?
Emergency fund or save for big purchases
The flexibility and the tax free growth make the TFSA a powerful piece to your financial plan. It can be used as a ‘Rainy day fund’ for emergency expenses or to save for large purchase such as a down payment for a home, new car or if you are expecting triplets.
Transferring money from your parents
Parents that would like to help their child buy a home or some other major purchase can contribute directly to the TFSA of the child. It can be done as a gift or a loan, in the case of a married child, proper documentation should be kept and thought should be given as to whether or not these funds should be comingled with the other family assets of the married child and their spouse or common-law partner. The TFSA could become part of the community property and would be subject to division if the child and their spouse have a separation or divorce.
Save more for your child’s education
Looking into the future of university costs, the lifetime $50 000 limits in an RESP will probably not be enough, especially if your child wants to be a doctor or ends up like Van Wilder. You can also use your own TFSA while the children are young and could then contribute directly to their TFSA’s when they turn 18. Caution, once in the child’s TFSA, you no longer have control or any legal entitlements to the money, so be sure to get receipts.
Where can I open one?
You can open a TFSA account at most banks, insurance and financial institutions. With most banks the TFSAs that are advertised are low interested savings account. You are not investing in anything and you will receive a return rate of 1 to 2% on your money. With a financial/investment company you can have a TFSA invested in mutual funds, GIC’s and other investments. Your money will grow but it is at risk of the markets and could end up with a lot less than what you contributed. With an insurance company you can open a TFSA and invest in segregated funds which are basically mutual funds but with certain guarantees. There is market risk, however with an insurance company they guarantee 75% of your capital at the end and 100% of it if you pass away. You have many options to choose from and you should meet with an advisor to find out which one would work best for you.
Why should I have one?
Two words: Tax Free!
I don’t know about you but I try to avoid (legally) paying taxes wherever I can. In most situations, withdrawals from an RRSP must be reported as part of the total income for the year and this amount will be taxed at your marginal tax rate. This increase in your income on your tax return can affect other benefits which you may have been eligible to receive if your income was lower such as GST/HST, provincial benefits, Canada Child Tax Benefit and Universal Child Care Credit.
With a TFSA, the income earned within the account nor withdrawals made from the account typically have no tax implications. Your income at retirement could potentially reduce or cut-off certain income-tested government benefits as well as prevent you from claiming certain tax credits. By using the savings from a TFSA for income enables you in this situation to build retirement savings without worrying about tax implications and its impact on retirement entitlements.
What’s the catch?
A big difference between an RRSP and a TFSA is that contributions to a TFSA are not tax deductible. Also, the interest paid on money borrowed (leveraged investing) to make a TFSA contribution is not tax deductible.
What’s the bottom line?
If you want to grow your money without paying taxes on it then the TFSA is right for you. Just keep in mind the four points:
- No Tax on investment income or withdrawals
- Contributions are not tax deductible
- The contribution limit for 2013 is $5500
- You can do more than use it as a basic savings account
As always I suggest you speak with a licenced professional independent advisor (like me! ), to look at your over-all financial situation and to help you get the maximum benefit of your TFSA. If you have any questions or would like to suggest a topic for me to write about please send me an e-mail.
Just say no (legally) to Tax!
Insurance Broker & Financial Services Advisor
Helping families piece together their financial puzzle
Member of the Independent Financial Brokers of Canada
The information is of a general nature only and does not take into account your individual objectives, financial situation or needs. It should not be used, relied upon, or treated as a substitute for specific professional advice. I recommend that you obtain your own independent professional advice (preferably me) before making any decision in relation to your particular requirements or circumstances.