TFSA for Beginners | Everything you need to know about Tax-free Savings Accounts
What is a TFSA? It's one of those things that we all have heard about. We see it when we go to the bank and it's something we think we "should" have. But most people have a vague idea of what it is and what it's meant for.
What I'm going to do is break down and simplify TFSAs by helping you understand what they are, what they're meant for, and important details to be aware of.
What is it?
The TFSA (tax-free savings account) is a program introduced by the government of Canada in 2009 to encourage Canadians to save more for their future. It's a "registered" account, meaning it's registered with CRA (Canada Revenue Agency) to receive tax benefits.
What a TFSA isn't is an investment. This is a very important distinction to help you understand what it's used for.
Investments vs Investment Vehicle
An investment is something you put your money into, in hopes that it grows. Examples of these include: mutual funds, index funds, exchange-traded funds, stocks, bonds, GICs, and savings accounts.
An investment vehicle is something like your RRSP or TFSA. These are the accounts you put your investment into.
The way I like to explain it is that your investments are like food. Your mutual fund, for example, is food. You can eat the food! However, the RRSP and TFSA are the plate you put your food on. You can't actually eat the plate (you can try if you want)! But what the plate does is it protects your food from the germs on the floor and on the table.
Back to investing, what RRSPs and TFSAs do is protect your investments from the germs that are called taxes! Each one has their own benefits, but what's important to recognize is that the TFSA is not an investment, but an investment vehicle to help your money grow with tax advantages.
Side note: Many people get confused because it's called a tax-free savings account. It's easy to see it as a savings account that you open at the bank, that grows tax-free. This is one possibility, but it's important to remember you can have many other investments (such as the ones I listed above) to grow in the account, aside from a savings account.
What is the tax benefit?
To better understand the tax benefit of a TFSA, you need to understand how taxes work for ordinary accounts. If you have an investment in a "non-registered" account (meaning it's not registered with CRA for tax benefits), you pay taxes on the growth on the investment.
A simplified example is that if you have $1000 in an investment, and it grows by 10% (for simple math), you make $100. What happens is that you include this as investment income when you file your taxes next year. This means if you're at a 30% tax bracket, you will pay $30 in taxes. You made $100, but you only keep $70. (This is oversimplified, but it illustrates the point)
What you can do, instead, is put that same $1000 in the same investment, but have that investment on a plate called a TFSA. What happens is that you get the same 10% return, but you keep the full $100 tax-free. Whether you keep your money in the account or withdraw it, the full amount that you contributed and its growth are both tax-free.
To sum it up, it's a simple way of making sure the money you invest grows tax-free.
What's the catch?
It may seem too good to be true, especially knowing CRA loves their taxes. However, there aren't many drawbacks to taking advantage of the TFSA! There are a few reasons, but two big things to be aware of are: the contribution limits and penalties.
There is a cap on how much Canadians can contribute into their TFSA. It starts when you turn 18, and you're given a set amount for each year you're 18 or over. In 2019, it's $6000. Meaning if you turned 18 in 2019, you can contribute $6000 this year (after your birthday). Below is a chart showing the contribution limits of each year.
The contribution limit is cumulative, meaning that if you didn't contribute the amount this year, it carries over to future years. This means if you were 18 or older during 2009, and you haven't contributed to your TFSA yet, you can put the full amount of $63,500 this year.
Although contribution limits start at age of 18, you can only open an account when you turn the age of majority. This is important to note if you live in provinces where 19 is the age of majority, like in BC. This means you can open a TFSA when you turn 19, but you get the contribution room of 2 years (for the year you turned 18 and this year when you turned 19).
What if you want to access your money?
The great thing about TFSAs is that if you take out money out of your TFSA, you get back the amount you withdrew as contribution room for next year. Assume you contributed the full $63,500 and you took the full amount out, you can recontribute it next year (plus the new additional room for next year). This makes TFSAs a great option for investing if it's for short-term or medium-term goals.
Keep in mind that you get back the contribution room for the amount you withdrew. This means that if your $63,500 grew to $100,000, then you get back contribution room of $100,000 next year! But, it's a double-edged sword. If your $63,500 dropped to $30,000, then next year you can only recontribute $30,000. This is important to know when withdrawing money out of the account. Your limit is valuable, so avoid withdrawing the money when the value of your account is down!
I don't like penalties :(
You want to be very aware of the contribution limit, because there are hefty penalties. You will get dinged 1% of the excess amount per month that you overcontributed. If you contributed $70,000 with only $63,500, you will get charged 1% per month for the $6500 you overcontributed ($65 per month).
This is especially important if you withdrew money from your TFSA this year! You want to remember that you get your contribution room back next year, not this year! If you contributed $63,500 and withdrew the full amount, you need to wait until next year to put it back in. If you put it back in this year, you will have overcontributed $63,500. This means you will pay 1% on that full amount per month, until you take it out or until next year when you get that room back.
What is TFSA great for?
TFSAs are a great tool to take advantage of whenever you're saving or investing. As mentioned, it's great for short-term or medium-term goals, such as for a car, a down payment for a house, education funds, or a vacation. This is because the money grows tax-free, you can withdraw the funds tax-free, and you regain the contribution room the year following the withdrawal.
But what if it's long-term? If it's for your retirement, you want to compare having your investments in a TFSA with an RRSP. I will have a follow-up blog on how RRSPs work, and a separate blog on comparing the two. Stick around, because there will be valuable information to help you make an informed decision. It's always important to evaluate which one is better for YOUR situation.
Regardless, TFSAs will be one of your best friends in helping you in your journey towards financial independence.