As long as I can remember Canadians have had income tax deducted from their paycheques. Taxes are a way of life and it’s hard to avoid them, whether you’re buying food, filling your car with gas or buying a stove. However, now Canadians have a new way to lower their tax burden and keep more cash in their pocket. Unlike a bank savings account where you pay tax on the growth in a tax-free savings account (TFSA) your growth is not taxed – more money for you.
I believe TFSAs are one of the most powerful savings tools Canadians have. A lot of clients have a TFSA and enjoy the tax-free growth it offers. It can act as an emergency fund, a way to save for vacations and big purchases, pay down your mortgage and even save for retirement.
Although some people understand the real value of a TFSA others get the wrong idea because the words “savings account” are part of the name. While you can hold a savings account in the TFSA, you could also use it for stocks, mutual funds, a segregated fund policy and guaranteed investment certificates (GICs).
Both TFSAs and registered retirement savings plans (RRSPs) allow you to grow your investments with a tax advantage. However, there are differences.
Contributing money to an RRSP can lower your income in a particular year, so you defer paying taxes on that income. Once invested, your contributions grow tax-deferred. That means you don’t pay tax on any earned income or capital gains until you take it out.
With a TFSA, unused contribution room can be carried forward like an RRSP, so if you can’t contribute the maximum amount in any given year you can wait and contribute larger sums in the future when you have more money available. When withdrawals are made, your contribution room is not lost and the amount of the withdrawal is added back to your contribution room in the following year.
Although contributions aren’t tax deductible, you don’t pay tax when you take the money out, unlike an RRSP, and you don’t pay tax on the investment income you earn while your money grows inside a TFSA.
The money you accumulate in a TFSA can be withdrawn at any time without tax consequences. There are no time limits for withdrawing and no restrictions on how you spend your money.
Withdrawals increase your contribution room in the year following the withdrawal, allowing you to save again for another purpose..
Who can contribute to a TFSA?
Any Canadian resident with a Social Insurance Number, who is 18 or older can contribute to a TFSA, as long as he/she has reached the age of majority in his/her province. With RRSPs you can start contributing as soon as you start working but your final contribution is permitted when you turn 71 at which time you are forced into taking an income stream by converting your RRSP to a registered retirement income fund (RRIF).
With a TFSA you don’t need earned income to make your contributions, and there are no income limits restricting who can contribute. The great thing about the TFSA is the contribution room. Not only can you withdraw the money and replace it at any time, your contribution room also carries forward if you don’t contribute the maximum.
For 2015, thanks to the recent budget announcement eligible Canadians are allowed to contribute up to $10,000 each. If you’re only able to contribute $5,000 in 2015 and you’ve never contributed before, you have $36,000 of contribution room available to you in the future. This means that you can contribute an extra $36,000 down the road. You could contribute $6,000 for the next nine years to “catch up.” On top of this, each year the Canadian government could offer an additional $10,000 of TFSA contribution room helping them grow more tax-free wealth. Do you see why I am so excited about this savings tool!
Using your TFSA to help accelerate your investment growth
Many Canadians use TFSAs as an emergency fund (my wife and I do this with a small portion of her TFSA). Many Canadian also use a high yield savings account or laddered GICs in their TFSA. However, this may not be the most efficient use of a TFSA (depending on the purpose of the savings). TFSA rules mean that there is a lot of potential for tax savings down the road.
Since you don’t pay taxes on your withdrawal, it may be better to have potentially higher yield investments in your TFSA like stocks, mutual funds or segregated funds. The potential larger gains will be tax free. It makes more sense to place potentially lower yield investments like conservative mutual funds or segregated funds and GICs into RRSPs.
Divide your long-term investment portfolio between your RRSP and your TFSA. Put the potentially lower yield investments like GICs and conservative investment funds into the RRSP. The earnings from these investments are generally fairly low, so paying taxes on them later wouldn’t cost you too much. Plus, you get the tax refund for your contributions now. Check with a qualified investment representative to help you determine the investments that are most appropriate for your investment tolerance and your desired time frame for the usage of the money.
The TFSA is great as a long-term income tax deferment. When you’re ready to use your accumulated savings you could draw a continual tax-free income from you TFSA. Or you could let it build over time. Either way, with these potentially higher-yielding investments the tax-free withdrawal aspect is very attractive. Even if you have to pay income tax now, the prospect of avoiding what will likely be higher taxes later is a good one.
If you’re pushing your contribution limits, it might not be prudent to include dividend paying stocks in your TFSA. They are already quite tax efficient. In fact, you might want to hold dividend paying stocks outside RRSPs and TFSAs. This could be accomplished with a non-registered investment account holding corporate class funds. Also, consider participating life insurance as another powerful tax-advantaged asset.
In most cases, my advice would be to max out both your RRSP and TFSA if possible, as a strategy to allocate your assets in a way that provides maximum potential advantage.