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Friday, October 24, 2014

TFSA – Part I: Misconceptions

Posted by Tim Stobbs on January 13, 2010

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.

Comments

15 Responses to “TFSA – Part I: Misconceptions”
  1. IngaG says:

    In my view, tax-free withdrawals make TFSA is the preferred vehicle for the aggressive growth oriented section of a portfolio. Of course, if you are comfortable with the higher risk that aggressive growth involves…

  2. CC says:

    Hey there :)

    Great point when you mention that most people think it is a great place for a savings account. This is so true… However, I’d say that it’s still a good start (better than not having a tfsa at all). Nevertheless, it is important to consider what types of investments you could put in it to maximize the tax benefits :) .

  3. Great post!

    Its good to know that accumulation room continues to grow each year prior to a person opening an account.

    Question
    For retired persons would it ever make sense to remove money from an RRSP and transfer it into a TFSA?

  4. Robert says:

    Canadian Money: It would make sense for a retired person to move money to a TFSA in two cases (that I can think of).

    First, if you have just retired and are living on savings or severance. If you have no taxable income, you could take $10,000 (basic deduction) from your RRSP/RRIF and pay no (or little) tax. Then, make your TFSA contribution for income and growth to be tax-free in the TFSA.

    Second, if you are over age 71, and the RRIF minimum provides more income than you need. (Example: at age 85, the minimum RRIF withdrawal is over 10%, but a sustainable spending rate is 4%-7%.) Pay the tax, then move the investments from the RRIF to the TFSA to provide tax-free income and growth for future use.

  5. I finally had a chance to look at the spreadsheet from before. Thank you for providing it. However, I had to change the numbers for my reality. The numbers come out equal for me.

    I have a $1000 to put towards my RRSPs and my vacations. If I put the full $1000 into my RRSP I can use the refund (or better yet reduced taxes) towards my vacation. However, if I use the TFSA I have to invest less in order to save for the vacation (A10-B10).

    Seeing as the spreadsheet is missing the growth, I’d expect that the RRSPs would end up ahead because there is more money to grow earlier on. 12000 in year 1 in an RRSP vs 7680 in TFSA.

    Is my math wrong? I suppose I could add in the compounding math into the spreadsheet and find out, but I have an Economics quiz coming up :)

  6. dlm says:

    This is good information. I could also use information on RRSP/GIC/RIFs — comparing policies at different financial institutions re withdrawals etc. It’s extremely difficult to track interest and withdrawals with several years’ contributions squeezed into one RRSP or RIF. Can you have many separate plans? ETC. Thanks.

  7. CPS says:

    This is a great summary of misconceptions. Often times these simple questions can be overlooked.

    I was curious about the multiple TFSA accounts. It seemed to be possible, but never had it confirmed.

    Thanks for sharing

  8. Robert says:

    Financial Student: What you’re missing is the taxes you’ll pay on the $12,000 (in your example) when you take it out of the RRSP before you can spend it. It’s fun to have $12,000, but it’s how much you can spend that really matters.

    Good luck with your quiz (although I’m sure you don’t need luck). :)

  9. Robert says:

    dlm: You can have multiple RRSPs, just like having multiple TFSAs, as long as you don’t overcontribute. Your question is really about GICs. An RRSP/RRIF/TFSA can hold almost any investment you choose. The redemption of a GIC/RRSP should be explained to you when you buy it.

    If you want someone to help you manage multiple RRSPs or various GICs within a single RRSP account, allow me to suggest working with a broker. Alternatively, you could keep them all at the same institution. That would simplify your life.

  10. Robert: I undersoodd that. I also see that you did have the interest calculation included in the spreadsheet and in my numbers it doesn’t matter which method I use according to the spreadsheet.

    The spreadsheet doesn’t show withdrawals though. With the RRSP you have an extra million to get growth from. So I expected that growth to be worth it.

    However, I just found the time to run the numbers and both fund run out at almost the exact same time. 1000 extra left in the RRSP. Not really worth it.

    Hmmm… Interesting. Thanks Robert.

  11. milind says:

    Hi there

    Can you transfer an RRSP to a TFSA without penalty

  12. Canadian Dream says:

    Milind,

    To my knowledge the answer is no. By removing the money from an RRSP you trigger a tax event, since the TFSA is funded with after tax dollars. So you can’t avoid the tax.

    Tim

  13. Robert says:

    Canadian Dream is right, the answer is no. Some people were swapping investments out of an RRSP for other investments in the TFSA (eg $5,000 of bonds moves from the TFSA into the RRSP, $5,000 of stock moves from the RRSP to the TFSA). This is allowed with the open account, but the government recently ruled that it is NOT allowed with the TFSA.

  14. Erick says:

    @Robert

    You said “although foreign currency is an eligible holding, I don’t know of any brokerage that will hold it for you”.

    The only company that I’m aware of that that currently allows you to hold and trade in USD is Questrade:

    http://www.questrade.com/trading/registered_accounts_tfsa.aspx

  15. Fiona Bailey says:

    I have GIG’s in my RRSP which are earning 4.5% Can they be moved to a TFSA if I pay income tax on the full amount. Please advise.

    Thanks

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