Understanding the Tax Free Savings Account (TFSA)

The greatest gift that Canadians have received from the government, lately, is a TFSA. Yes, it is another investment vehicle bundled with rules, terms and regulations that are to be strictly followed to avoid penalties imposed by the Canada Revenue Agency. The name Tax Free Savings Account does not really explain the power and benefits of proper use of this account. This is NOT a savings account.  Unfortunately, most of the time, TFSAs are underused or misused (used incorrectly).

Therefore it is best to review the features of TFSAs and compare them to RRSPs:

• TFSA is more FLEXIBLE than an RRSP! You can withdraw money out of it, at any point in time and the amount of $$$ will be saved as a possible deposit back into the account in the future. For example, if you have invested (well) $10,000 and it grew to become $17,000, and you withdraw the money (going on vacation) and then you have the funds available for re-deposit, you will be able to put back the $17,000 that you have withdrawn, not just the $10,000 which you initially invested!

• The TFSA can hold a variety of investment vehicles including GICs, stocks, bonds, mutual funds, exchange-traded funds, etc. exactly like an RRSP. However, unlike the RRSP it is not beneficial to hold US denominated investments in the TFSA as the US is not recognizing the “tax free” status of the TFSA. These investments will be taxed by the US government and that tax cannot be recovered.

• Withdrawals and deposits back into a TFSA are calculated within the frame of a “calendar year” i.e.  January 1 to December 31.  For example, if you have $31,000 in your TFSA in 2014 (or more than that, if you have invested the money well and it grew) and you wish to withdraw $5,000, you can do it, but you will not be able to put it back during 2014 calendar year. But if you only have $20,000 in your TFSA in 2014 (i.e. you have $31,000 - $20,000 = $11,000 of unused contribution room) and you wish to withdraw $5,000, and later in the same year you have the funds available to put it back, you can do it during 2014 (because the contribution room for the 2014 calendar year is still available $11,000 - $5,000 = $6,000). Yes, it is a little complicated.  The rule is not quite the KISS type, but that is where you can get help from a qualified professional.

• In the event of an over-contribution to your TFSA, you will be taxed 1% of the excess amount every month that the extra money is in the account. Contributions are limited to $5,000/year (2009-2012) or $5,500/year (2013-current). However, unused contribution room is carried forward from year to year.

• Contributions to a TFSA are “after-tax money” and will not be deducted from your taxable income.

• Any individual who is 18 years old, has a Canadian social insurance number and is a resident of Canada has a right to open a TFSA.    

• There are no tax consequences when your personal TFSA accounts are transferred from one financial institution to another, if the issuer and receiver execute a direct transfer on your behalf.

What is the best way to use a TFSA?

Should the TFSA be used as a short-term savings tool or for my retirement?

• TFSA can be used for either, but you’ll get more benefit if you use it for long term goals. You have to let the compounding interest do its magic and shelter the highest income earning assets from taxes.

• TFSA can be used as a Tax Free Income Generator in retirement – an instrument that will not affect your social benefits (it will not create a claw back on your OAS).  If you use a product which will generate a guaranteed income and you have this product sheltered inside a TFSA, the income will be forever yours and tax free!

In conclusion, it is best to review your own personal financial situation with a qualified professional to ensure that you are taking full advantage of the generous government gift.