It's no secret that investment income in Canada faces high taxation. Registered retirement plans provide a way to defer some taxes. The most effective strategy to shield investment income from taxes is investing in a Tax-Free Savings Account (TFSA).
A TFSA is an investment vehicle where income from investments and withdrawals remain untaxed, hence the name 'tax-free.' Canadian residents aged 18 or older with a valid Social Insurance Number (SIN) can contribute to a TFSA up to a specified limit, which we'll discuss below. Notably, non-residents can contribute too, but they face a 1% monthly tax on funds left in the TFSA.
In some provinces and territories, the age of majority is 19. In such cases, contributors must be at least 19 years old.
Only the account holder can contribute to and withdraw from a TFSA. However, individuals can give money to a spouse or common-law partner for them to contribute. The subsequent withdrawal belongs to the spouse.
An individual can have multiple TFSAs in their name, across different institutions. However, the total contributions to all TFSA accounts must not exceed the allowed contribution room.
How to Open a TFSA?
Various financial institutions, including banks, credit unions, insurance and trust companies offer the option to open a TFSA. While it's possible to hold multiple TFSA accounts simultaneously, your total contributions to these accounts must not exceed your available TFSA contribution room for the current year.
To initiate a TFSA, you must complete the following steps:
- Contact your chosen financial institution, credit union, or insurance company (the issuer).
- Provide the issuer with your Social Insurance Number (SIN) and date of birth to register your qualifying arrangement as a TFSA. In some cases, supporting documents may be required.
TFSA Contribution Limits
TFSA contribution limits are set annually. Here are the contribution limits since the TFSA's inception in 2009:
- 2009 to 2012: $5,000
- 2013 and 2014: $5,500
- 2015: $10,000
- 2016 to 2018: $5,500
- 2019 to 2022: $6,000
- 2023: $6,500
These limits are indexed to inflation and rounded to the nearest $500. Exceeding the contribution room incurs a 1% monthly tax on the excess amount. Contribution room comprises the remaining limit for the year plus all contribution limits or unused room from previous years after turning 18. For example, someone who turned 18 in or before 2009 can contribute up to $88,000 in 2023.
Qualified Investments
A TFSA permits various investments, much like an RRSP. These include cash, GICs (guaranteed investment certificates), bonds, mutual funds, stocks listed on a designated exchange, and certain stocks of small corporations. Foreign funds are allowed but must be converted to Canadian dollars for reporting.
In-kind contributions are possible; assets already owned can be deposited at their fair market value. This may trigger a taxable capital gain if the fair market value exceeds the purchase price. For instance, if an individual buys a stock for $100 in 2021 and contributes it to their TFSA in 2022 when it's valued at $120, they'll pay tax on the $20 capital gain.
Transferring assets from a registered retirement savings account can be done similarly. If the transfer occurs immediately, the investor only pays tax on the fair market value of the asset withdrawn, per RRSP withdrawal tax rules.
Investors can transfer assets between different TFSA accounts without it being considered a withdrawal.
Withdrawals
Withdrawals from a TFSA have no tax consequences. Investors can withdraw any amount at any time, completely tax-free. Each withdrawal increases the contribution room in the TFSA accounts by the same amount, effective the following year.
For instance, an investor with no contribution room in 2021 who withdraws $2,000 will not contribute further that year. However, their contribution room for the following year (2022) will be the $2,000 freed-up room from 2021, plus the annual contribution limit of $6,000, making it $8,000 for 2022. If an investor has enough contribution room, they can re-contribute the withdrawn amount in the same year.
For example, an investor with a $5,000 contribution room in 2021 withdraws $4,000. They can re-contribute $4,000 in 2021 without exceeding the contribution room, leaving an additional $1,000 contribution room. The contribution room for the following year, in this example, would be $4,000 of freed-up room, plus the ending room of 2021, $1,000, and the annual contribution limit for 2022, $6,000, totaling $11,000 for 2022.
Tax Implications
The TFSA is tax-free, but specific scenarios carry tax implications. Contributions to a TFSA aren't tax-deductible. In contrast, RRSP contributions are, allowing investors to defer taxes. Exceptions necessitating tax payments in TFSA usage include exceeding the contribution room or non-resident status. Taxes on prohibited or non-qualified investments amount to 50% of their fair market value, although refunds can be granted in some cases. Refer to the Canada Revenue Agency website for further information. For more information on these matters, please refer to the Canada Revenue Agency website.
When to Use a TFSA?
The Tax-Free Savings Account (TFSA) is a valuable tool for Canadian investors. It offers tax-free investment and flexible withdrawal options. To contribute to a TFSA, individuals need to have reached the age of majority, typically 18 in most provinces, and stay within their contribution limits. Unlike the Registered Retirement Savings Plan (RRSP), which primarily serves as a retirement savings vehicle, the TFSA allows investors to save for various life expenses.
With a TFSA, Canadians can save for major purchases like homes or cars, pay off loans, set aside money for entertainment such as vacations, or grow their capital tax-free. Importantly, they can withdraw funds at any time without penalty. It's worth noting that TFSA contributions are not tax-deductible, which differs from RRSPs.
Choosing between a TFSA and an RRSP depends on individual circumstances. Those in higher tax brackets who wish to defer taxes until retirement may prefer RRSPs. Conversely, individuals in lower tax brackets aiming for higher returns might opt for TFSAs. Investment goals and timelines also play a significant role. If the need for funds arises before retirement, a TFSA provides flexibility, whereas those solely focused on retirement savings may favor RRSPs. In conclusion, the decision between TFSA and RRSP should be based on a careful analysis of your personal financial situation if you can't maximize both.