Today is the first of a three part series on TFSA’s from our guest blogger, Robert, who provided such an interesting debate on his first guest post that we brought him back. Enjoy. – Tim
We are now in the New Year and the RRSP season is upon us. But this year, like last, we now also have a new opportunity to contribute to a tax-free savings account (TFSA). I think that this is an ideal time to begin thinking about how a TFSA contribution might work for you. Today, I will address many of the misconceptions I’ve heard regarding TFSA’s. In the next installment, I will suggest some of the best uses for a TFSA. Finally, I will recommend some strategies where a TFSA makes most sense.
The first, and possibly most common, misconception about a Tax-Free Savings Account is that it is a savings account. This is understandable. I can think of a couple good reasons why it was named as it was, but the name can be confusing. A more appropriate name would have been either tax-free plan, because a TFSA is closely related to an RRSP. It is an account, specially registered with the government and held in trust by a trustee. It can hold any eligible investment and it has rules about deposits and withdrawals. Just like an RRSP, you can hold either a directed (basic) or self-directed TFSA. In the case of a directed TFSA, the options are limited to those offered by the financial institution. This is almost always a high-interest (currently around 1%) savings account. But any brokerage can open a self-directed TFSA for you. This especially makes sense if you have other investment accounts, such as a self-directed RRSP, already. If you open a self-directed TFSA, you can hold a high-interest savings account within it. Or you could choose GICs, stocks, bonds, preferred shares, mutual funds or cash in any proportion. One caution: although foreign currency is an eligible holding, I don’t know of any brokerage that will hold it for you, outside of a trust (such as a mutual fund or a savings account).
The second misconception is related to contribution room. I have had people ask me to open an account for them, indicating that they won’t be making a deposit this year. When I ask why, they explain that they want their contribution room to accumulate and not be lost. In fact, you don’t need to open a TFSA in order to accumulate contribution room. Contribution room accumulates for every adult Canadian (over the age of 18) each year. In 2009, we each had $5000 of contribution room. In 2010, we each have another $5000 of contribution room, and it will accumulate each year by $5000, increased by the rate of inflation in $500 increments. Unused contributions can be carried forward and, unlike RRSPs, withdrawals result in new contribution room. Here’s an example. Richard turns 20 in 2013, and now has $15,000 TFSA contribution room. He opens an TFSA and deposits a gift of $15,000 from his grandparents. He uses it to buy mostly dividend-paying stocks, but also one small mining company recommended by an uncle. Richard is very lucky, and by 2014 the mining company shares have tripled in value. The new value of the TFSA is $20,000. Richard takes out the $20,000 to buy a home. Remember that he has $5000 more contribution room from the current year. In 2015, on his notice of assessment, Richard will see that he has $30,000 TFSA contribution room: $20,000 from the withdrawal in 2014, plus $5,000 for each of 2014 and 2015. Notice that the withdrawal actually gave Richard new room, since the market value was greater than the cost.
On a related note to the above misconception, it is possible to open as many TFSAs as you like just like an RRSP. The government allows each adult $5,000 contribution room each year, and it is your responsibility to ensure that the total of your contributions doesn’t exceed the limit. I recommend only having a single TFSA, for simplicity.
The final misconception is that RRSPs save more tax. RRSPs and TFSAs both save taxes, but in different ways. For an RRSP contribution, you receive a tax deduction and possibly a refund. That is not the case with a TFSA. However, with the TFSA, withdrawals are tax-free, whereas you will pay taxes on the full amount of an RRSP withdrawal. If you are in the same tax bracket at the time of the contribution and the time of the withdrawal, you would save the same amount of tax either with an RRSP or a TFSA. Let’s look at an example. In 2013, Martin contributes $15,000 to an RRSP and gets a tax refund of $5000, which he invests outside the RRSP. Over the next 7 years, his accounts double to $40,000 and he makes a withdrawal. After taxes of $10,000, he is left with $30,000. Martin’s sister, Mary, contributes $15,000 to a TFSA, taxes already paid. Over 7 years, the account doubles to $30,000, which can be withdrawn tax-free.
The misconceptions about TFSAs that I pointed out make the account more valuable than some people realize. It is a useful tool that makes saving and investing easier. Next time, we’ll look at some of the best uses for TFSAs. In the comments, please share what you have learned about TFSAs or what you consider to be little-known facts.
Robert is a Certified Financial Planner (CFP®) in Calgary who develops financial plans and also gives objective advice regarding all types of savings and investment products. He believes that not having money worries can allow people to spend their time in other meaningful areas of their life. Robert is married, has three children and is involved in his church, in his community association and in the school. Robert is on track to retire at age 42, although he and his wife plan to change careers and work for the benefit of children.