What is a TFSA?
Why it should be part of your savings plan.
While many Canadians have Tax-Free Savings Accounts (TFSAs), there is still a lot of confusion around what they are actually for. Let’s clear up a common misconception: the TFSA is not designed to be just a simple cash savings account.
TFSAs are actually tax-registered investment accounts that can hold a wide variety of assets. They were started in 2009 as a way to encourage Canadians over 18 to save by providing an account that allows your investments to grow tax-free.
How does a TFSA work?
Every year you can contribute a certain amount to a TFSA, which you open through a financial institution, such as your credit union. All of the investments that you hold within the account grow completely tax-free – this includes interest, capital gains and dividends.
Unused contributions can be carried over to the following year. It’s important not to over-contribute, however, because penalties are high. You can check your contribution limit by calling the CRA’s TIPS line at 1-800-267-6999.
What investments can you hold in a TFSA?
The TFSA is particularly effective at building investments, especially those with high-growth potential, because your gains are completely tax-free. Some of the investments you can include in a TFSA include:
- Stocks in publicly-listed companies
- Mutual funds
- Exchange traded funds (ETFs)
- Guaranteed investment certificates (GICs)
- Government and corporate bonds
- Real estate investment trusts (REITs)
There are some restrictions, however, such as that stocks must be listed on a designated stock exchange. Check with your financial institution to ensure that your investments are eligible because penalties can be high for unqualified investments.
Benefits of having a TFSA
It’s not surprising that over 14 million Canadians have a TFSA, given its advantages:
- Your investments grow tax-free, including interest, capital gains and dividends
- It’s flexible: you can take out as much as you like at any time with no tax or penalty
- A wide variety of investments can be held within it
- Withdrawals have no negative impact on government benefits
- You don’t need earned income
- It can be switched over to your spouse or another beneficiary on death
Disadvantages of a TFSA
While having a TFSA may seem a no-brainer for many people, it does have some drawbacks:
- Unlike with RRSPs, your TFSA contributions do not lower your taxable income, so they bring no immediate tax benefit
- You may have to pay withholding tax on foreign dividend payments
- There can be heavy penalties if you over-contribute or hold non-qualified or prohibited investments
- It has a low contribution limit compared to RRSPs
- You can’t claim capital losses within a TFSA
When does it make sense to invest in a TFSA?
TFSAs are an excellent choice for anyone looking to grow their savings tax-free, while being able to withdraw funds at any time with no penalty.
For this reason, TFSAs are perfect for short- and mid-term savings goals, such as a down payment on a home, paying for a wedding or an emergency fund.
In certain situations, TFSAs also make sense for long-term savings, such as retirement. If you’re in a low tax bracket, the immediate tax benefits of an RRSP may not be worthwhile, so a TFSA can be a good way to grow savings that won’t be taxed when you retire. Also, if you’ve maxed out your RRSP contributions, a TFSA is ideal for boosting your retirement savings.