TFSA 101

Today, I’d like to take this opportunity to demystify TFSA, a great savings vehicle that the government of Canada has provided to its residents since 2009.

It is a vast topic, so I’d like to first focus on what this vehicle is and its benefits and common pitfalls.

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First thing first: What is TFSA?

  • TFSA stands for Tax-Free Savings Account.
  • It is a registered savings account provided by the government of Canada for all individuals who are 18 and older with a valid Canadian social insurance number.
  • The program started in 2009.
  • Every year, every eligible individual can contribute up to a fixed dollar amount into a TFSA. The exact contribution room depends on how much you have contributed and withdrawn in the past and how much new contribution room is available in the new year.

Nice things about TFSA

The best thing is that any withdrawal that you make from your TFSA account is tax free.

  • This is definitely the biggest advantage a TFSA has. In Canada, all sources of income above the basic personal amount is taxable. For example, for tax year 2019, the basic personal amount is only at $12,069 according to CRA. For most people with a relatively stable income stream (e.g., working at a 9-to-5 or having a modestly successful small business), it is not very difficult to go over that amount.
  • The taxation rules for savings vehicles vary depending on what instruments you choose. Generally speaking, if we rank by taxation percentage, interests are taxed the most, at your marginal tax rate, followed by dividends, and then capital gain. For a more detailed explanation of the taxation rules, please check out my article here. For the sake of this discussion on TFSA, the most important thing to remember is that the government will want a piece of your pie regardless of whether you park your money in a regular savings account, or in bonds, or in stocks.
  • By putting your savings into your TFSA account, however, the money can grow tax-free. Yes, that means that even if your stocks double or triple in price, you will not have to pay a cent of tax on it! How sweet of a deal is that!
  • However, the flip side is that if the investment in your TFSA account drops in value, then you cannot claim capital loss on that investment against your capital gain from a regular investment account.

The annual contribution room, although limited, is cumulative.

  • The contribution room is set by the government, and it is generally around $5000 – $6000 a year. This means that if you were at least 18 years old in 2009 and haven’t contributed any money to your TFSA account since then, then today, you have a total contribution room of almost $70,000. That is definitely a nice starting point for a nest egg, isn’t it?
  • For your actual contribution room available, please log in to your CRA account for details.

You can have multiple TFSA accounts across different financial institutions.

  • It’s been more than 10 years since the government first introduced the Tax-Free Savings Account. TFSA has now been fully integrated into our banking system. This means that almost all financial institutions, including probably all the ones you use, offer TFSA.
  • The government does not pose a limit on how many TFSA accounts you can hold. You can open as many TFSA accounts across as many different financial institutions as you like. But you need to make sure that you do not contribute beyond the contribution room available to you in any given year.
  • Of course, to avoid unnecessary complexity, I do not recommend that you open so many accounts that you forget where they are. But you may want to experiment with opening one or two for different purposes, for example, one for regular savings, and one for investment.

You can hold various types of financial instruments within your TFSA

  • TFSA is not just a savings account. In fact, you can use it for your regular savings, to buy term deposits, and to purchase bonds, mutual funds, and stocks. All these common financial instruments can be held in a TFSA.

Despite all the nice features, TFSA also has some common pitfalls. Make sure that you don’t fall for any of these to avoid a hefty penalty.

There is a still a contribution limit every year.

  • Yes, although contribution limit is cumulative, it is still limited. This means that you cannot contribute beyond the contribution room set out by the CRA.
  • An easy mistake that a lot of people make is that they forget that the amount withdrawn from their TFSA account will only be added to the contribution room for NEXT YEAR, NOT THIS YEAR.
  • For example, say on January 1, 2020, you have a total contribution room of $7,000. This is the sum of the new $6,000 contribution room for 2020, and $1,000 from unused contribution room from prior years. On February 20, 2020, you contributed a total of $7,000. Then comes April 15, 2020. You need to do a roof repair, so you withdraw $3,000 from the account to cover the expenses. Now, you cannot put $3000 back into your account in 2020, because you have already used up your $7,000 contribution room for 2020 on February 20, 2020. You will have to wait until 2021 for that $3,000 contribution room to free up.
  • If you did withdraw and re-contribute during the same year, and your total contributions (just contribution, not counting withdrawals) exceed the contribution room available, then CRA will charge you a penalty. The penalty is calculated based on the highest excess amount for the month, at 1% per month. The penalty stops only when you remove the money from your TFSA, but you still need to pay the penalty already incurred.
  • What if I made an honest mistake? You may ask. Your best bet is to withdraw the money as soon as you discover the mistake to limit the penalty amount, and appeal to the CRA to see if they can in anyway waive the penalty.

CRA website’s contribution room calculation is not accurate at the beginning of the year.

  • If you log into My Account on the CRA website, you will see that it does have a section that tells you how much contribution room you have for the current year. However, you must note that the information may not be accurate, especially in the beginning of the year. This is because it takes some time for your various financial institutions to send your contribution and withdrawal information to the CRA.
  • For example, this year, I noticed that CRA did not finish updating my contribution room calculation for 2020 until the end of April.
  • This means that it is extremely important for you to diligently track your contribution and withdrawal amounts, so comes January of the new year, you know exactly how much room you have. The CRA is not going to be responsible for the accuracy of your contribution history, but they are going to come after you to collect penalty if you do not play by the rules.

Your eligibility for a TFSA starts the year that you turn 18.

  • Although it is true that the TFSA program began in 2009, it does not mean that everybody automatically gets to have contribution room going back to 2009. You are only eligible for this account when you are at least 18 years old, and you can only start accumulating contribution room when you turn 18.
  • A good friend of mine made a costly and time-consuming mistake when he erroneously thought he had a lot of extra room. He turned 18 in 2013, and so, he was not eligible for the contribution room from 2009 to 2012, totalling $20,000. He was ordered by the CRA to pay back quite a big penalty because he over-contributed. Although he ended up succeeding in his appeal, he still had to go through a long and painful process that took him almost half a year.

You must have a valid social insurance number.

  • For most people residing in Canada, this shouldn’t be a problem. However, if you are a non-resident without a social insurance number, even if you are physically present in Canada, you are still not eligible.

Not everything related to TFSA is tax-free.

  • If you borrow money to put into TFSA, the interest on the borrowed money is not tax-deductible.
  • Any administrative fee associated with opening a TFSA is not tax-deductible, either.
  • Although you can hold a variety of financial instruments in a TFSA and the gains are tax-free, there are some non-qualified investments that are not eligible.
  • You cannot carry a business inside a TFSA. A common example is day trading. You will be liable for the tax owed on the income earned from day trading inside a TFSA.
  • Note that the list is not exhaustive. When in doubt, please reach out to your tax advisor, your financial institution, or give a call to the CRA.

This is it for today’s TFSA 101. I hope the information above gives you a good overview of this savings vehicle. As I said in the introduction, TFSA is a vast topic, so I will continue posting a few more articles to discuss items such as how to optimize TFSA, and how to track contribution room. Stay tuned!

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