If you have set yourself a savings goal, a Tax-Free Savings Account (TFSA) is one of the best ways to meet your financial objectives. Whether you’re saving for a vacation, a car, or retirement, TFSAs are an excellent choice.
TFSAs are increasingly popular amongst Canadians for helping them save successfully. This guide will cover TFSAs and what benefits they bring compared to other savings instruments, such as RRSPs.
What is a TFSA?
While TFSA means Tax-Free Savings Account, Canadians may not be familiar with this savings option. Certainly, a TFSA is not like a traditional savings account you might hold with a bank. Those accounts earn little in interest and are often limited in various ways. With a TFSA, you have more freedom to save as you want, including being able to choose between several financial tools.
For example, you can add to a TFSA from stocks, traded funds, bonds, GICs, and even cash deposits. TFSAs have been available in Canada since the federal government debuted them in 2009.
How does a TFSA work?
While TFSAs may seem complicated on the surface, they are easy to understand and to manage. Flexibility is a big part of the TFSA model because you can add money from various financial instruments and withdraw money freely.
If you decide to take money out of your TFSA, the amount you withdraw will be added to the following year’s contribution limit. Perhaps more interesting is that the contribution limit rolls over to the next year if you don’t make a deposit that year. But note that there is a lifetime contribution limit too.
Benefits of a TFSA
As the name suggests, a TFSA comes with government-backed tax breaks for Canadians who have a savings goal they want to fulfil. Importantly, the tax exemption does not come as an instant tax break like an RRSP contribution. However, you will get the tax benefits further down the road since any gains in your investments within a TFSA won’t be taxed. That is because you already paid tax on the money you deposited into the TFSA.
Another good thing about a TFSA is that you can have as many of them as you want, allowing you to potentially save beyond the contribution limit of a single TFSA.
TFSA contribution limits
TFSAs come with a contribution limit that defines the maximum amount of money you can deposit per year. It is worth pointing out the contribution limit will change each year, so it’s best to check historical limits (including this year) before opening a TFSA. Interestingly, it is possible to deposit more than the contribution limit but doing so incurs a 1% excess contribution fee that is payable monthly until the surplus is withdrawn.
When you make a withdrawal from a TFSA, the amount of money you remove will be added to the contribution limit for the following year. In 2020, the contribution limit was set to $6,000, with a lifetime limit of $69,500.
As you may expect, the lifetime limit is the total amount of contribution you are allowed through the life of the TFSA. In other words, you cannot deposit any more than this amount into the account (without incurring a penalty). Remember, it is possible to have multiple TFSAs, so you are not necessarily limited to the lifetime contribution.
TFSA vs. RRSP
Make no mistake, an RRSP (Registered Retirement Savings Plan) is a fantastic savings tool. Both types of savings accounts have plenty going for them, so it is worth weighing up the benefits of RRSP and TFSA to decide which is best for you. According to RATESDOTCA, there are things about RRSPs Canadians need to consider when determining if it’s the right savings vehicle for them.
RRSPs are a perfect choice if you are earning over $50,000 and preparing financially for your retirement. On the other hand, if you earn a lower amount and believe you might need to access your money, a TFSA is a good option. Of course, some people who already contribute to an RRSP also decide to use a TSFA alongside it.
It’s also worth remembering that a TFSA is ideal if you are not necessarily saving for retirement. In other words, if you want to save for a car or anything else that will mean you need to withdraw money, a TFSA is a good choice.
TFSA and taxes
Because TFSAs are tax-free savings accounts, most Canadians don’t worry about tax and focus on the rules and contribution limits. However, it is worth taking the time to understand the tax mechanisms to avoid any unwanted surprises.
Most investments into a TFSA are tax-free, while most gains on the account (interest, dividends, capital gains) are also not taxable. This changes when you contribute above your monthly limit. As we have noted, when this happens, you will receive a penalty tax of 1% on your highest excess contribution.
For example, if you went over your contribution limit by $1,000 in January 2020 and leave it that way, you’ll end up paying a $10 penalty tax per month for the remainder of the year.
How to open a TFSA
TFSAs are available to all Canadians aged 18 years or older with a valid social insurance number (SIN). You can get a TFSA through a credit union, financial provider, or insurance company that offer these types of accounts. When opening a TFSA, you will probably also have to provide some ID to prove who you are. Opening a TFSA is a smooth experience that can be completed in around 10 minutes.
Moving an existing TFSA between financial institutions
If you are moving banks and want to take your TFSA with you, the process is straightforward. However, there may be a fee attached to such a transfer, although this can sometimes be reimbursed by the new financial institution. The best advice is to check the policy on such fees.
There are no tax penalties for moving a TFSA from one financial institution to another.
Limitations of a TFSA
Unfortunately, no financial service is perfect, so there are some things you should consider when thinking about a TFSA. The good news is none of them is a deal-breaker. For example, while it is good that you can open as many TFSAs as you want, it can sometimes be confusing managing multiple accounts. The biggest danger here is that you over contribute and end up having to pay a 1% fee each month.