In the last few weeks, I've had some delightful conversations with people about tax-free savings accounts (TFSAs).
There has been one consistent theme: Nobody knows all the rules, and a small lack of knowledge could mean missing out on some big opportunities. So let's do a quick TFSA review.
(Besides, talking about TFSAs prevents me from bragging about our team being named by Wealth Professional magazine as one of Canada's top 50 financial advisers, and mentioning that would just be gauche.)
TFSAs are a special type of account registered with the government. They were introduced in 2009 and can be held at a bank or credit union, investment dealer, discount broker, mutual fund company or life insurance company.
The account is separate from the investment options selected. That's an important concept. For example, once a TFSA is opened, the money deposited could be put into a daily interest savings account, GIC term deposit, mutual funds or individual stocks and bonds.
There is no tax deduction for the deposit, unlike an RRSP. So why do we care?
The magic of the TFSA is investment income earned on those investment vehicles inside the account is tax-free, and all future withdrawals are also tax-free. Again, this is the opposite of the RRSP.
When using the TFSA as an additional retirement vehicle, you have the efficiency of tax-free compounding but none of the damage that RRSP or RRIF withdrawals cause to your taxable income after retirement.
RRSP and RRIF withdrawals also push up your net income (line 236 on your return), which limits your eligibility for income-tested government programs such as the guaranteed income supplement, old-age security, the age credit, GST credit and at younger ages, the child tax benefit and employment insurance benefits.
Limits: Every taxpayer who has reached age 18 within a year is entitled to that year's TFSA contribution. If the amount is not used in the current year, it carries forward and is added to the limit for the next year, and so on.
The limit for 2009 through 2012 was $5,000 per year (total $20,000) and $5,500 for each of 2013 and 2014. Therefore, a person who was 18 in 2009 has been able to contribute $31,000, including the 2014 deposit.
Tax-free withdrawals are allowed at any time. As well, the amount of any withdrawal is added back to your contribution limit the following Jan. 1. For example, if you withdraw all $31,000 in 2014, you can deposit it again in 2015.
Strategies and uses: So how do you make this work for you? Let's say your $31,000 was invested today in, for example, mature company shares paying three per cent dividends and growing at three per cent a year, for a total return of six per cent. It would grow to almost $100,000 in 20 years, assuming all dividends are reinvested. The $69,000 of investment growth would not be taxed and the entire amount could be withdrawn without even appearing on your tax return.
Maximizing the benefits of the TFSA as an accumulation vehicle to grow capital for future retirement income is, in my view, the best possible use. The illustration above shows why.
Alternatively, the TFSA can be used to house an emergency fund or for short-term savings, but with interest rates on short-term vehicles below two per cent, the potential benefit is pretty small.
However, as a general rule, any accumulation of investments outside your RRSP should be used to maximize your TFSA, as any amount of tax sheltering is a good thing.
Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
David Christianson, BA, CFP, R.F.P., TEP, is a financial planner and adviser with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.