The Real Deal with TFSAs
Everyone’s talking about TFSAs.
The acronym is thrown around, but not everyone knows what it means. Many people open one because they heard it’s a good idea, but aren’t exactly sure why and how to use it.
What are you doing with your TFSA? Do you fully understand its benefits and how you can best use it? If you want to make sure, read on.
TFSA stands for Tax-Free Savings Account. What does tax free mean? It means that any money you earn inside the account – like interest, dividends or gains in the stock market – are forever tax-free. Forever. You will never have to pay tax on the income you earn in a TFSA.*
Income earned on investments is taxable if the investments are sitting in a regular account (ie: not a TFSA, RRSP, RESP or RDSP). Interest on a GIC? Taxable. Money you made when you sold your Apple stock? Taxable. Dividends from your mutual fund? Taxable. Holding your investments inside a TFSA means you’ll never pay tax on any of this income. To limit the government's lost tax revenue, there is a maximum amount you can contribute every year.
Here is an example of what this looks like. If you make $500 in investment income, the amount of tax you pay varies depending on the type of income it is and, of course, your tax rate. (Here I assume a 31.5% income tax rate.)
The amounts in the red box are the tax savings you get from using a TFSA. This might not look like much, but if you assume you can save this amount of tax every year, and you re-investing the income you earn, the compounding effects is dramatic.
For example, if you invest $10,000 and it earns interest of 5% per year for 20 years, you’d have almost $8,000 more if you held the investment inside a TFSA rather than in a regular, taxable account.
What investments can I hold?
The “savings” part of the TFSA name is a bit of a misnomer. Yes, you can save in a TFSA, but you can also invest inside a TFSA. A TFSA is like a bucket. A bucket can hold many things: sand, shells, sticks, rocks. Similarly, a TFSA can hold many things: stocks, GICs, mutual funds, exchange-traded funds, and bonds. It’s not just a savings account.
Don’t assume that just because you have a TFSA that your money is invested. Unless you’ve had a conversation with someone about what to invest in or you are doing it yourself, there’s a good chance that your money is sitting in a savings account earning very little income. It’s time to find out what your TFSA money is doing and figure out if it’s invested in the best place.
Which account do I need?
There are different types of TFSA accounts and which one(s) you need depends on what kinds of investments you want to own.
TFSA savings account – This account will just hold cash, like a regular savings account. You can open one of these accounts at a bank or credit union.
TFSA mutual fund account – You can also open this account with a bank and it would allow you to invest in mutual funds. To invest, you’d go through your bank branch.
Self-directed TFSA account – With this account, you can manage your own investments. You’re able to hold a wide range of investments like stocks, ETFs, bonds and GICs. You can open this account with a bank or with online brokers like Questrade or WealthSimple.
TFSA with a robo advisor – This account gives you access to a robo advisor, a service that invests your money into a handful of ETFs on your behalf.
If you already have a TFSA, job one is to find out what kind of account you have. Call someone at the institution where you have your account and find out. Ask what kinds of investments can be held in the account.
Next, think about what kind of investments are appropriate for your TFSA: is this money you’ll need soon or do you plan on leaving it alone for many years? If you’ll need it soon, then a savings account is probably the right choice. But if this is retirement money, you should really be thinking about investing in the stock market, and that means mutual funds or ETFs. Once you’ve figured out what you want to own, go and open the right account.
How many can I have?
Did you know that you can have more than one TFSA? You might have a TFSA savings account to hold cash or GICs, and a self-directed TFSA to buy ETFs. It doesn’t matter how many you have but keep in mind that all of the contributions you make across your TFSA accounts are added up to determine how much you’ve contributed for the year. For 2023, the contribution limit is $6,500. If this is all the contribution room you have, and you put $2,000 in your TFSA savings account and $2,000 in your self-directed TFSA, then you only have $2,500 left to contribute for the year. The limit isn’t per account – it’s across all accounts.
When you have several TFSA accounts, it can be hard to track how much you’ve contributed in a given year. It’s important to keep track, though, because over-contributing can result in a penalty.
The last great thing about the TFSA is that it’s so flexible. You can take money out whenever you want and there is no penalty. Just transfer the funds from the TFSA to your chequing account when you need it.
Even better, you don’t ever lose the contribution room – when you withdraw, you can put that amount back in the following year. It’s amazing! This flexibility means that TFSAs can be used for both short-term goals like buying a new car and long-term goals like retirement.
Anyone who has an income and who has money to set aside can benefit from a TFSA. The higher your income tax rate, the more tax you’ll save, but the account benefits people in all tax brackets.
The things you heard about how great TFSAs are? It’s all true. Anyone with some money sitting around should have a TFSA.
*Well, almost never. If you get dividends from a company outside of Canada, you will have to pay some tax on them.