TFSA - not just a savings account!
Well, we’ve made it! 2020 has passed us by, and I think we are all ready and looking forward to what 2021 has to bring. One thing that each new year brings for us Canadians that are over age 18 is another years worth of TFSA (Tax Free Savings Account) contribution room.
Since their introduction in 2009, TFSAs have become a popular savings vehicle, and it’s easy to see why. The contribution limits are simple, there is no variance depending on your income, and if you need the funds you don’t take a tax hit to withdraw early from your account. Combined with tax free growth, why wouldn’t you want one of these accounts?
I am a big fan of TFSAs, and there are even more benefits to the TFSA than listed above - but one thing they suffer from seems to a lack of marketing. I would like to blame the name - perhaps when people see Savings Account in the name rather than Savings Plan (like an RRSP) they mentally put a TFSA in a bank account bucket, much like a chequing and savings account as opposed to an investment account like their RRSP. According to a Bank of Montreal survey, only 49% of people realized they could hold another type of investment other than cash in their TFSA, and cash made up 38% of all assets held in TFSA accounts.
While a big factor in reaching your goals is saving consistently, if you are leaving your TFSA account in cash you are missing out one of the biggest advantages of the account - growth is not taxed, and withdrawals are not taxable. With this, you want to maximize growth in this account, and I think we all know cash and GIC’s are not the vehicle to do that.
Let’s take a step back and look at what a Tax Free Savings Account is, how it works, and what you can do with it.
First introduced in 2009, the Government of Canada set a $5,000 annual contribution limit, with the limit increasing
in increments of $500 tied to inflation (with the exception of 2015 which was increased to $10,000 by the Conservative government and subsequently reversed by the succeeding Liberal government).
So who can contribute? Any Canadian resident that has a valid SIN who is 18 or older may open and begin contributing to a TFSA. If you do not contribute in a given year, the contribution room is carried forward. This means if you were over 18 in 2009, have been a continuous resident, and have never contributed to a TFSA you will have accrued $75,500 up to and including this year (2021).
So, let’s say you’ve been sitting on some cash and decide to go all in and put the full $75,500 into your account today - you’ll get a big tax refund too, right?
Unfortunately, that is one drawback to the TFSA - contributions are made after-tax, meaning there is no deduction for money put in to the account. On the other hand, when you need to withdraw funds down the line,
withdrawals are not taxed at that time (if you think of the fact that at some point you always have to pay taxes, TFSAs are pay now, RRSPs are pay later).
We will come back to withdrawals later and the pros and cons of paying tax now versus later, but for now let’s stick with the money that has been deposited into your account.
Now that there are funds in your TFSA account here are the 4 reasons a TFSA is a great account that can maximize growth and double as an emergency fund:
1) It’s not a “savings” account. What can you hold in a TFSA? In short, pretty much anything that can be held in an RRSP. While that does include cash and GICs, it also includes bonds, stocks, mutual funds, exchange traded funds (ETFs) and some options. You can hold any qualified investment in your TFSA (if it trades on a stock exchange that’s listed as a “designated stock exchange” by Canada’s Finance department, and there are over 46), and you can even contribute in other currencies (although these will be reported at their Canadian equivalent and contribution room cannot be exceed in Canadian dollars).
Can you hold foreign securities or ETFs? Sure, but be aware that foreign dividend income may be subject to foreign withholding tax, which can reduce returns.
2) It is flexible! Say you’ve been diligently saving and some disaster strikes and you need to withdraw from your investments. A withdrawal from your TFSA is completely tax-free (unlike RRSPs), and next year the amount of your withdrawal will be added back as contribution room (say you needed $30K today, in 2022 you would have the presumed $6K in contribution room for the year + $30K withdrawn in 2021 for a total of $36K available in contributions). It is important to note however that you cannot recontribute funds you’ve withdrawn within the same calendar year - this runs the risk of you overcontributing and facing penalties. It is good to note that the full amount of your withdrawal is added back to contribution room - say your $75,500 was invested and had grown to $80K and you needed to withdraw all of it - the full $80K is restored as contribution room in the following year, not just the $75,500 in initial contribution room. This flexibility is why TFSAs make a great emergency account.
3) Funding retirement is made through tax - free withdrawals, not converting your account to a RRIF. If we jump forward in time and assume you are getting ready to retire, we will now circle back to the pay tax now versus paying tax later discussion.
Most people who have taken an introductory finance course will say time
value of money applies, and you should want to pay tax later so you can invest more money tax sheltered. And that’s a valid point, except that we deal with marginal tax rates - so we have an element of forecasting what the future will hold for us.
Because withdrawals from your RRSP will be taxable as income, you need to ask yourself - what income level am I at now, compared to what income level I expect to be in retirement? Keep in mind, once you turn 71 you will need to convert your RRSP into a RRIF to begin drawing income, with a minimum withdrawal amount each year that is fully taxable as income. If you have an RRSP account worth millions of dollars in retirement, your income (and the tax associated with it) could easily reach higher tax brackets than today. This brings up the question - if you have a current marginal tax rate of 30.50%, is it worth taking a tax deduction now, if it means you will be paying tax at a 48% rate when you withdraw it?
On the other hand, because funds invested in a TFSA account have already had the tax paid on them, when you withdraw there is no tax payable. While no one can predict what will happen in the future, the general rule of thumb is - the higher your tax bracket today, the more beneficial contributions to your RRSP are in the current year. If you are in a lower tax bracket, taking advantage of TFSA contributions may make more sense for you.
4) And finally, when planning your retirement income we need to consider your income from all sources including government benefits. Generally speaking, any benefits that are income tested (such as OAS and GIS) will count RRSP/RRIF income and income generated from non-registered accounts to determine your eligibility, however withdrawals from your TFSA are generally not considered for income testing. This can allow you to blend your withdrawals from multiple accounts to minimize your likelihood of income tested claw backs.
As great as TFSAs are, they are unfortunately not for everyone - if you are an American, TFSA accounts have no special status under the Internal Revenue Code, like RRSP accounts do - and because you do not receive tax slips for your TFSA you cannot apply for foreign tax credits for this account.
If you aren’t sure if a TFSA is right for you - or you are but just don’t know where to start, I am happy to help you get started. You can reach me here.
Elyce Harris is a CFA Charterholder working with Cornerstone Investment Counsel, a registered ICPM in Alberta, Canada. She is also a licensed insurance broker in Alberta, Ontario, and PEI. While every effort is made to ensure the accuracy of statements, errors may occur. If a specific stat or carrier policy is cited, a source will be provided, however this is not done for generalizations.