Today, I want to talk about a relatively new investment tool—the Tax-Free Savings Account (TFSA). The Tax-Free Savings Account was launched in 2009 and many people are becoming aware of it today. But how much do you really know about them? What are the rules you need to follow? What is the right time to buy a TFSA? Here, I will discuss the top 10 myths and misconceptions about the TFSA and suggest some strategies that will help you make an informed decision about whether or not a TFSA is right for you.
Top 10 Myths
1. A Tax-Free Savings Account is for savings
While a TFSA is primarily used for savings, the name is a bit misleading. It really should be called a “Tax-Free Account” and when used properly, it can also be a powerful investment tool. The idea behind a TFSA is that whatever you make on the account is going to be completely tax free.
2. Tax-Free Savings Account withdrawals will cause clawbacks of government benefits
It’s in the name—tax free. All withdrawals from a TFSA will not affect any government-related income tax benefits. So if you’re receiving Old Age Security (OAS), a Guaranteed Income Supplement (GIS) or other similar benefits, TFSA withdrawals won’t change that.
3. Use it or lose it
Many people think that if you don’t contribute to your TFSA this year, you would lose that contribution room. This is simply not true. Whatever you don’t use during the year gets carried forward and is added to next year’s benefits. For example, the contribution room limit is $5,500 per year. If you don’t make use of this amount, it gets added to next year’s contribution room and you can actually put in up to $11,000 the following year.
4. Always maximize your RRSP first, and then contribute to a TFSA
Everybody’s tax situation is different, so it really depends on the tax rate at the time of your withdrawal. If your income is pretty high now—meaning you’re at a higher tax bracket—take advantage of your RRSP first. By putting money into a RRSP today, the tax savings you are getting on it will be greater because the tax rate at the time of your withdrawal is going to be lower in the future. On the other hand, if the tax rate is higher in the future, focus on your TFSA first. This way, you don’t have to pay taxes when withdrawing from your TFSA at a later date. Lastly, if the tax rate is the same today and at the retirement, both a TFSA and RRSP are equally effective tax savings alternatives.
5. A TFSA must be transferred, used up or completely withdrawn by a certain age
Again, this is false. Unlike a RRSP, which requires you to convert it into an income fund at the age of 71, a TFSA has no restrictions. You can keep money in it for as long as you want. You can also withdraw at any time with no negative consequences. Remember, withdrawals from a TFSA are not taxable, so it won’t affect your tax return.
6. Since it’s made in Canada, everything in the plan must be 100% Canadian
A TFSA is a great solution in Canada, but you don’t have to limit yourself to Canadian investments. Many people assume that they can only buy a TFSA from a bank, and as a result, the money in their account is sitting in cash. But did you know that you can actually buy it from any financial planner who is licensed to sell investment solutions? Take advantage of other investment options such as mutual funds, stocks and bonds.
7. You’re not allowed to have multiple TFSAs
There is no limit to the number of accounts you can have, but I would recommend keeping things simple. The only restrictions are based on your contribution limits, i.e. how much you are allowed to put in each year. These numbers are tracked, not the number of accounts you have. If you do over-contribute, there is a penalty of 1% per month on the excess contribution, so like I said before: keep it simple.
8. Tax Free Savings Accounts are protected from creditors
This is an interesting one because assets in a TFSA are not protected from creditors in cases such as bankruptcy, whereas they are in a RRSP. If you are in a high-risk industry with lots of liability or a business owner who wants to be prepared against creditors, there is a solution. Hold your TFSA with an insurance company and invest in segregated funds. This way, creditor protection can be applied to your assets.
9. Tax Free Savings Accounts cannot be used as collateral for a loan
Most people assume that a TFSA has the same rules as a RRSP, since it is another form of tax sheltered investment. The big difference is that if you are looking for a loan and you need some collateral, you can use your TFSA; however, with a RRSP, you can’t.
10. Investment income generated within a TFSA is tax free for everyone
While assets in a TFSA are completely tax free, this rule does not apply to everyone. If you are a U.S. taxpayer who is a resident in Canada, you are required to report the income earned on a TFSA. The U.S. does not recognize the tax shelter that a TFSA provides to Canadians.
Tip: U.S. taxpayers could consider taking out the money and putting it in a more tax-efficient vehicle.
1. Transfer investments with high taxable income, such as bonds, into a TFSA
Put bonds and stocks into a TFSA to take advantage of the tax-free growth. The TFSA shelters those assets going forward and the income would not need to be reported on your tax return, which ultimately reduces your tax bill.
2. Income Splitting Strategy
A higher-earning spouse can contribute to a lower-earning spouse’s TFSA with no attribution.
3. For seniors and retirees, use your TFSA as the first source of income
Again, remember that withdrawals from a TFSA are tax-free. Defer your income from your RRSP or RRIF (if you’re above the age of 71), so that you can defer your tax bill as well.
4. If you over-contributed to a TFSA, work with the CRA
Since its launch in 2009, there has been a lot of confusion and millions of Canadians have genuinely made the mistake of over-contributing. If you received a letter from the CRA, respond within 60 days and they will help you fix the problem.
Now that you know the basics about Tax-Free Savings Accounts, you are ready to take the next step! I encourage you to contact us or your financial planner to arrange a meeting and set up your TFSA today.
TFSA vs. RRSP