A Tax-Free Savings Account (or TFSA) is one of the more flexible financial tools available to us. It’s great for the long-term, short-term, term deposits—all the terms, really. It allows you to earn interest tax-free and can be used for any kind of savings like an emergency fund, a regular savings account or even investments for retirement.
There are many ways to maximize your TFSA’s potential and it all depends on your own financial goals. Don’t worry, we’ve broken it all down so you don’t have to.
Before we dig deeper, let’s quickly go over what a TFSA is.
A TFSA is a government program that allows tax-free savings to those 18 or over with a valid social insurance number.
When you put money into a regular savings account and earn interest, you have to pay the government tax on that money because it’s considered income. With a TFSA, you don’t get taxed on the interest you earn on your investment, even when it’s withdrawn (unlike RRSPs). For example, if you put $1000 into your TFSA and earn $100 in interest, you won’t have to pay taxes on the $100 earned.
Every year, you’re allowed to deposit a specific amount of money into your TFSA. This number is your contribution room. The government decides a new contribution room every year. You start to accumulate contribution room from the year you turn 18 and it carries forward your whole life. For example, say your contribution limit is $6000 this year because you just turned 18. If you’re unable to make a contribution, you don’t lose this contribution room and can still make the contribution in later years.
How a TFSA can fit into your financial plan
Since TFSAs are so flexible, they can be used as a tool in many different stages of your financial plan. Think of a TFSA as an umbrella, with all the different ways to use it underneath the umbrella. This could include a regular or short-term savings account, but there are more ways to use it depending on your financial goals.
Many people put money into their TFSAs for investing because it saves them the cost of paying taxes on the interest earned.
You can use your TFSA to hold your savings, term deposits, mutual funds, stocks, bonds, and exchange-traded funds. If you’re uncertain about what type of investment to choose, it’s the perfect time to complete a Money Chat with our Investment Team.
To simplify investing, you can set up a scheduled transfer called a pre-authorized credit (PAC) to your TFSA. You pick the amount, the date, and where the money comes from. Easy.
With RRSPs, you can only contribute a percentage of your earned income. A TFSA gives you the breathing room to put more money aside for retirement. For people who have defined benefit pensions (a pension or retirement savings plan that both an individual and their employer contribute money into), a TFSA can be a great way to supplement retirement income.
As mentioned above, one of the features of a TFSA is that unused contribution room can be carried forward to future years. Another feature is that if you withdraw funds, you don’t lose the contribution room forever; you can re-contribute the next fiscal year. This is a big contrast to an RRSP, where you lose the contribution room once the funds are withdrawn. With a TFSA, you’re able to recontribute 100% of the funds that you’ve withdrawn, even if that amount included some interest or investment returns. You just have to wait until the following calendar year to recontribute.
For example, imagine in 2019 you invested $1000 into your TFSA, earned $100 in interest and withdrew the full amount ($1100). In 2020, you’d be able to re-contribute $1100, plus any unused contribution room carried over through the years.
What to watch out for
It’s important to be aware of your contribution limit. If you over-contribute to your TFSA, the Canadian government will charge a penalty of 1% per month, of the amount that was over contributed. For example, if the over-contributed amount was $1000 then the penalty would be $10 per month.
To look up your contribution limit, visit the My Account section on the Canada Revenue Agency (CRA) website. Once you know how much you’re allowed to contribute, just set up a PAC for that amount. Set it and forget it. More information is available on the CRA’s website.
Once you turn 18, the government will let you know how much you’re allowed to contribute every year. If you’re a little confused about how much contribution room you have, the safest option is to get in touch with the CRA. However, they have additional helpful information on their website.
Need more help with your TFSA?
Our skilled Investment Team is here to help. We’ll help you create a financial plan tailored to your individual needs and goals. So book a money chat with us today.