The most common questions we tend to receive regarding the TFSA are usually, "How does it work?", and often in quick succession, "Is this right for me?". In today's post, we'll explore both of those questions, and help you make an informed decision as to whether this account is right for you.
Who Can Have One?
Any Canadian citizen over the age of 18 with a Social Insurance Number.
How Does It Work?
The Tax-Free Savings Account isn't exactly an account in the strictest sense of the word. What we mean by that is, it isn't just an account (like a regular Chequing or Savings account) that one would simply dump money into to gain interest.
In fact, what most Canadians don't know, is that you can have a Tax-Free investment in any vehicle you want to: a savings account, GICs, mutual funds, even stocks, through a brokerage account. One is able to invest any way they want to, in any kind of investment that fits their preferred method of savings and investing.
What's in it for you? Typically, you pay tax on your investment income and interest. Every year, each financial institution you hold a Non-Registered investment or savings account in will send you a T-slip for all of the interest earned on your investments in the previous tax year. With this account, you can deposit up to $5000.00 CAD per year into an investment or savings account registered as a Tax-Free Account.
- A Non-Registered Investment is (generally) anything that isn't part of your Retirement Savings Plan. You don't pay taxes immediately on RRSP investments, because RRSPs are tax-deferred, meaning you don't pay taxes on those investments until they're withdrawn, and in contributing to your RRSPs, you don't pay income taxes on that money you contributed out of your pocket.
- Your savings accounts, GICs, stock trading accounts, and mutual fund investments that aren't part of your RRSP are generally considered to be Non-Registered Investments.
Therefore, you pay less taxes on your investment income. Therefore, it saves you money.
Seems too good to be true, doesn't it?
It does, but there are limitations to the account in how it operates:
1) Contribution Limits
The primary limitation to the TFSA is the limited amount of money one can deposit into it. The Federal Government is setting an annual maximum contribution limit of $5000.00. Meaning, one can only deposit $5000.00 new dollars into the account or investment per calendar year.
Here's how it works:
- January 1st, 2009: The Annual Limit for 2009 is set at $5000.00
- January 2nd, 2009: I deposit $3000.00
$5000.00 2009 maximum
- $3000.00 contribution
= $2000.00 remaining
"Do I lose my contribution room if I don't deposit the $5000.00 maximum?"
No. It's carried forward to what you're allowed to contribute the following year. Let's go back to our example:
- January 1st, 2009: The Annual Limit for 2009 is set at $5000.00
- January 2nd, 2009: I deposit $3000.00
- January 1st, 2010: The Annual Limit for 2010 is increased by $5000.00. My remaining contribution from 2009 carries forward, meaning I can deposit up to $7000.00 in 2010.
$5000.00 2009 maximum
- $3000.00 contribution
= $2000.00 remaining
Then...
$5000.00 2010 maximum
+ $2000.00 2009 unused contribution room
= $7000.00 maximum contribution room
"Can I withdraw from the account or withdraw the investment?"
Yes. However, the limitations of your investments still apply. For example, if you're cashing a GIC, typically you pay a penalty to break it early, or in the case of a stock or a mutual fund, it needs to be sold at its current market price, which may be lower than what it was when you purchased it.
Also, and this is very important, any withdrawals you make from the TFSA affect your contribution room. What you withdraw you do get back in contribution room, but not until the following year. In our previous example, we showed how contributions work:
$5000.00 2009 maximum
- $3000.00 contribution
= $2000.00 2009 contribution room remaining
At this point, we have $3000.00 in our tax-free investment or account. Now let's make a withdrawal of $1000.00
$3000.00 balance in TFSA
- $1000.00 withdrawal
= $2000.00 balance in TFSA
Now, it looks like we should have an extra $1000.00 in contribution room, because there is now less money in the account. However, remember what we mentioned above: your annual contribution room is measured by deposits of new dollars. Meaning, in our example, we've already deposited $3000.00 for 2009, and therefore, can only contribute a further $2000.00 in 2009.
Now, let's see what things look like for 2010. First, let's go back to our example on how contributions affect our carry-forward room:
$5000.00 2010 maximum
+ $2000.00 2009 unused contribution room
+ $1000.00 2009 withdrawals
= $8000.00 maximum 2010 contribution room
You get your contribution room back after withdrawing from the account or investment, but you can't use it until the following year.
"Does my investment income or capital gains influence my contribution room?"
No. Only your original investments are measured into the contribution room. Your investment income and capital gains are not.
2) Is It Right For Me?
As impressive as the TFSA is as a tax-saving device, if you can believe it, it's not for everyone. The suitability of a particular investment vehicle depends on each and every person. It can be said generally that there are many trends and generalizations to how people invest, based on their investment experience, their time horizon (meaning, when in the future they plan to use the funds they're investing), and most importantly, where they are in their lives. All of these things influence how different investment vehicles have different suitabilities for each person.
First, let's look at how suitable it is depending on how long you want to invest those funds for:
Short Term Investing:
Short-term investing is generally understood as investing without definite time horizon, or investing specifically to have funds available after a fixed period of time that's one year or less. Short-term investors want a lot of liquidity in their investment- meaning they want it cashable and available in cash in very short order without penalty. If you want somewhere to temporarily park some funds for a specific purpose (say, a major purchase), the TFSA may not be right for you.
Why?
Think about the contribution room. In a very short amount of time, you'll deposit money into the account or investment, make some interest or gains (hopefully), and withdraw it. If this is all done in less than a year, you'll eat away at your contribution room quickly, and won't be able to replace the funds right away. Let's face it, an account or investment vehicle that you can't put money into is pretty much useless.
If your intention is to save or invest for a very short time, the TFSA is probably not right for you. Consider a regular Non-Registered savings account or investment.
Long-Term Investing:
Long-term investing is generally understood as being anything two years or more, where one doesn't necessarily want a lot of liquidity in what they've invested in. This is money they're parking into an investment or account either for no specific purpose in the short term, or for something specific in the future (a major purchase, perhaps).
This is where the account really begins to benefit its users. Long-term investors prefer to be able to continually put money aside and invest it for their desired purpose. While the limits on contribution room does make the TFSA a little inflexible, it does give a long-term investor the ability to top up that investment with each increase in the contribution room over many years.
When we look at how the TFSA operates, it's really the way contribution room is handled that decides who would benefit the most in terms of time horizon. Why would you put your money into something you could only use once per year (assuming you were to maximize your contributions)?
Next, let's look at the TFSA in terms of what you want to invest in:
Savings Accounts
Every financial institution offers savings accounts; accounts with no maximum contribution room, that offer a fluctuating rate of interest, often with a minimum balance needed to gain interest at all. Using your TFSA as a savings account benefits you if you want to deposit funds on an ongoing basis in instalments. (say, $50 or $100 every paycheque, for example). It gives you the flexibility to deposit as little or as much as you want to up to your maximum for that year, with no minimum deposit necessary.
If your intention is to have something you can occasionally toss funds into, on a regular or irregular basis, the TFSA as a Savings Account is right for you. First, it gives you that flexibility to put as much as you want into it upwards of your maximum contribution room in any amount you want to. It's very flexible, there's typically no minimum balance to gain interest, and major financial institutions have (thus far) priced the interest rates higher than other savings accounts.
However, you also need to keep your contribution room in mind. The other side of having this flexibility and liquidity is that you can also withdraw funds at any time. It was mentioned above that if you plan on using these funds on an occasional basis, i.e. only saving for a short term before using the funds, this will not benefit you.
- An ideal solution to this scenario is to use a regular Non-Registered savings account.
Any interest you make on the balance is not taxed.
GICs
GICs (or Guaranteed Investment Certificates) are offered by every financial institution for investors who want security in their investments, and want to make those investments in lump sums. Your original deposit (often referred to as the 'Principal Investment') is guaranteed, and you are also guaranteed an interest rate over a prescribed period of time (say, 2% for two years).
If your intention is to throw a lump sum of money into an investment and not have to worry about the market affecting that investment, a GIC is right for you. The important thing to keep in mind is that GICs do have minimum investment limits, typically of $500.00 to $5000.00 depending on the bank. If you are dropping a large sum of money into an account for a long period of time, and don't want to risk that money, a GIC is right for you.
Any interest you make is not taxed.
Mutual Funds & Stocks
Mutual Funds are, in a general sense, bank-controlled professionally-managed fund portfolios that invest in particular markets or sectors, and the those funds are made up of multiple major companies from those sectors. They can be purchased in units at a price per unit, and each unit will be made up of securities held in those companies. The big plus side is that since they're purchased in great volume by the bank for those funds, it's actually cheaper to purchase investments in particular sectors or companies through mutual funds, since the cost per unit is lower.
Mutual Funds are affected by the market, so there is the possibility that your original investment will be affected by fluctuations in the market. That being said, you also have a much greater potential for return on your investments if the market fluctuates in your favour.
Typically, you pay taxes on capital gains, which are the proceeds you gain from selling your funds or stocks at a profit over what you bought them at. This is where the TFSA really begins to shine.
Why?
The market is not predictable. The returns on your investments are also not predictable. With something like a GIC, you know exactly what you'll get out of it. With a fund or stock, you don't, but you generally hope and expect it to perform better than what it was when you bought it. Your stock or fund value could double overnight, and you'd pay for that gain. The TFSA means you don't have to.
Funds and stocks have the greatest opportunity to gain value, and as such, this is where your greatest potential tax savings are. If you're the kind of investor who prefers to put money into the open market, a TFSA Mutual Fund or Brokerage Account is right for you.
Any capital gains you make are not taxed. By the same token, you can't claim any capital losses.
Conclusions
Hopefully this was useful to some of you. The TFSA is nothing short of a convoluded investment and savings vehicle that may leave you second-guessing its usefulness. It is not right for everyone- no investment or savings vehicle is. However, with some of the examples we've just illustrated above, the account can be useful for you, depending on what kind of an investor you are.
Any questions or comments, please leave them below!
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