Why Tax Free Savings Accounts Are Still Misunderstood
The 2008 Federal budget introduced the new investment vehicle called the “Tax Free Savings Account.” It allows Canadians aged 18 and over to contribute the dollar limit for the year, plus any unused contribution room from previous years and any amount you withdrew the year before.
Starting in 2009, contribution room accumulates every year. The annual amounts are as follows:
- 2009 to 2012 – $5,000 each year
- 2013 to 2014 – $5,500 each year
So, as of 2014, the total contribution limit is $31,000.
Related: Ways to save inside your TFSA
It sounds quite simple, but it is one the of most misunderstood savings/investment vehicle around. Entire books have been written on this one topic.
How well do you know how Tax Free Savings Accounts operate? These are some of the most common misconceptions I have run across. For fun, I’ll turn it into a quiz.
True or False?
Deposits to a TFSA:
- Aaron is 16-year-old high school student who has scored a well paying job this summer. He will earn at least $5,000 that he can contribute to a new TFSA to enable him to save for university.
- 21-year-old Brigit received an inheritance from her aunt. She will deposit $31,000 into her TFSA.
- Her 28-year-old brother, Conrad, also inherited. He had not previously opened a TFSA so this year he can contribute only $5,500 and must wait till January 2015 to deposit a further $5,500.
- 71-year-old Dick must stop contributing to his TFSA.
All these situations are false.
Related: Using TFSAs in retirement
Aaron must wait until he turns 18 on May 13, 2016 before he can open a TFSA. He can then make the full contribution amount allowed for that year.
Brigit can only contribute $21,000. She turned 18 in 2011 and makes her calculations from that date.
Conrad can contribute the full $31,000 limit for this year even if he is just opening his account now.
There is no age limit on TFSA contributions (unlike RRSPs) so Dick can deposit for as long as he is able to.
Withdrawals from your TFSA:
- Zander contributed the maximum allowed each year for a total of $31,000. He withdrew $20,000 last month to purchase a car. He is expecting a large bonus in the fall and can redeposit the entire withdrawal amount at that time.
- Yasmin has also contributed $31,000. Her investments have grown to a total of $55,000. She withdraws the full amount. Next year she will be able to redeposit the original $31,000 plus the new annual amount of $5,500.
- Xena has managed to contribute a total of $15,000 since 2009. She withdraws $10,000. She will have to wait until 2015 before she can replace the withdrawal amount to avoid penalty.
Again, these statements are all false.
Related: Where to invest for short term goals
Zander must wait until January 2015 to redeposit the amount he withdrew.
Yasmin can replace the full withdrawal amount of $55,000 in 2015.
Xena has unused contribution room of $16,000 so she can redeposit her $10,000 this year. She should keep careful records if this becomes a regular occurrence.
Other misconceptions:
- Logan assumes that the term “Tax Free Savings Account” means that he can only open a savings account at his bank or credit union. He feels it is useless to open an account given the low interest rates available on savings accounts.
- Marissa purchased some shares in EFG Company that have since dropped considerably in price. She sells the shares and takes a capital loss.
- Nolan carefully purchases a portfolio of U.S. Dividend stocks in his TFSA because non-resident withholding tax is waived on registered accounts.
- Oscar wants to transfer his account. He can withdraw his funds and redeposit them at another financial institution without penalty.
- Penelope is told that any investment growth in her account will be favorably taxed.
False, again.
Related: TFSA versus non-registered account
Logan is not limited to a cash account. He can invest in various vehicles such as GIC’s, bonds, mutual funds, stocks and ETF’s.
Since the account is tax-free and capital gains are not taxed, capital losses cannot be used to offset income. If Marissa sells her losing shares she will have to hope that she can make up the loss with better investing.
U.S. withholding tax on dividends is only waived on U.S. stocks held in an RRSP. Nolan will receive a reduced dividend amount.
Oscar must use the required transfer forms to switch his TFSA to a different financial institution to avoid penalty.
The Tax-Free Savings Account is just as it says. Deposits are made with Penelope’s after tax money and all returns generated – interest, dividends, capital gains – are tax free and government benefits or assistance programs are not affected by income earned within.
Conclusion
You can find more information on Tax Free Savings Accounts at www.cra-arc.gc.ca/tfsa/
If you want to avoid confusing “government-speak,” I recommend Gordon Pape’s excellent revised and updated book on the topic – “Tax-Free Savings Account – How TFSAs Can Make You Rich.”
Another misconception is that you need cash to contribute to a TFSA. You can contribute equities and they are transferred at their fair market value. Also, lots of people don’t realize that income or gains create contribution room within a TFSA. For example, in a TFSA if you buy stocks for $10k and sell them for $30k then withdraw the $30k it becomes available as a contribution the following year (on top of the regular annual amount)
Good points Dan. Thanks.
Yes, TFSA’s are a very important financial tool for a person and family’s future.
This misunderstanding of TFSA’s and how long term income tax free growth, interest, capital gains, dividends etc. can make the main difference of just surviving or getting by modestly and having a real, strong financial foundation for the future.
Most Canadians don’t understand that by each 18 year old and older that maximizes their TFSA contribution limit of $5,500 a year can be worth millions together working as a family.
4 family members putting $5,500 a year and compounding their money at a modest 4.50% will be worth $2,411,238 income tax free.
This is $879,840 in TFSA contributions and $1,531,398 in compound interest and other compound growth at 4.50%.
This works out to an average of earning $38,285 per year income tax free.
This means 36.48% is TFSA contributions and 63.52% is compound interest, growth.
Saving and investing discipline using TFSA’s, RRSP’s etc. is the key.
Very unusual family with 4 adults in it for so long. Most of us are single or with one partner at the end of accumulation.
Robert, This is an example for the total of 2 adults and 2 adult children.
My main point was this allows for income splitting and a financial strategy on how to give an immediate family a long term financial plan.
Divorce, separation, death, disability, illness can occur but they will always be better off than what many Canadians do by being in debt, little to no savings and having all their wealth or net worth in an illiquid asset called the primary residence.
Huh. I didn’t know that withdrawing investments creates contribution room! Interesting.
I’ve recently started using my TFSA as part of my retirement savings rather than relying just on the RRSP. True, I won’t get the tax credit now, but I’m hoping to build a tax-free income stream for the future. I just hope the government doesn’t change the rules too much before I retire!
In your second group of examples you say: “Yasmin can replace the full withdrawal amount of $55,000 in 2015.” She can actually contribute $55,000 + $5500 = $60,500 in 2015, can’t she?
@xoxox: Yes, indeed. Yasmin can replace her full withdrawal amount AND make an additional annual contribution in 2015.
Good article. I think the Yasmin example is true, but of course that is not her limit.
The real trick is balancing the various types of accounts. I have corporate, personal, RRSP and TFSA brokerage accounts for example. At some point I have to decide when to take CPP and OAS. All are governed by quite different laws and rules. The trick is finding the optimal flow from each source. For a person accumulating wealth the end game needs considering.
I am off topic. But the bigger picture always looms.
@Robert: I had to reread my Yasmin example to make sure I had it right – late nights packing and organizing our move, you know.
You are able to replace the entire withdrawal amount – original contribution plus growth (as per reply to xoxox).
You make a good point that retirement income from various sources need to be managed for optimal flow and tax efficiency.
Thanks.
Very good point about the TFSA not just being a savings account for “cash”. I think the name confuses people.
I can’t say I ever thought of putting cash in one except for very short periods of time. But you are right about it being a good point – a lot of the ads seem to point in that direction.
@Elizabeth and with reference to Rick’s 4 adults savings.
I would almost be willing to bet than in the next 40 years some finance minister will be looking at these TFSA savings and drooling at the mouth. They will either change the rules or maybe do a means test for OAS or something like that.
Get in now while the getting is good and for us people who are getting long in the tooth it is almost free savings. As long as we invested well and did not lose the monies to some scam artist.
I think the reason why people are so scared of this is the overcontribution each year. Case in point, my friend needed to raid the TFSA to buy a new car for her job which was perfectly fine. She then came into a lump sum which she promptly put into the TFSA. Unfortunately, that meant she grossly overcontributed. Now she won’t touch it for fear of happening again. She also had the poor benefit of her “advisor” telling her that it was perfectly okay to re-contribute the money within the same year.
That just means that your friend needs to educate herself. Being scared is a terrible excuse to not take advantage of a great financial tool. Maybe you should point her towards these blogs/articles?
I actually have been doing that so she’s learning more. She was also hosed on the other investments. She has already ditched her advisor but is not ready to go alone yet.
Yikes. That’s terrible luck.
I wish that there was a way for ‘advisors’ to get reprimanded for handing out horrible advise to their clients. Could she possibly report them?
She has actually. I don’t know anything more than that, unfortunately. One of the things that she’s learning is doing a “play investments” where she learns the in’s and out’s of investing as if she was actually going to buy those stocks, GICs, etc., complete with spreadsheets and tracking and so on. She’s going to do this for a year while reading up more then slowly dip her toes into the water so to speak.
Without being too literal, I had a question on this one:
“21-year-old Brigit received an inheritance from her aunt. She will deposit $31,000 into her TFSA.”
You say False. I say it’s true, she can totally do that. She just can’t do that without incurring a penalty, which is what I think you meant, but didn’t say. Maybe I’m just too literal.
(Compare that to the 16 year old opening a TFSA, that wouldn’t happen).