A Tax-Free Savings Account is a program of the Canadian government that allows you to invest your money, with any dividends and capital gains being tax free. No one likes paying taxes so it seems like a dream come true. While this article is titled TFSA advantages and disadvantages, the pros definitely win this one. Read on to learn more about the TFSA benefits.
What is a Tax Free Savings Account (TFSA)?
A Tax Free Savings Account is an opportunity to invest your money, generate some dividends or capital gains, and not pay any tax on your investment growth. You simply open the TFSA with your financial institution, make a contribution and decide on your investment choices.
With an RRSP contribution, you get a tax credit. On the other hand, when you put money in your TFSA it is after tax. In other words, it won’t reduce your tax owing when you file your income tax return in April.
How does a Tax Free Savings Account (TFSA) work?
It’s pretty straightforward. You are free to invest your money as you wish. If you are a conservative investor, put it into very safe GICs. If you love risk, invest in small cap startups with the hope that the company turns into the next exponential growth story. Or choose a path between the two extremes.
A key feature is that you can withdraw money at any time. A lot of financial advisors urge people to put aside an emergency fund in case you need to put new shingles on your house. The TFSA is the perfect vehicle for this since there are no tax implications to withdrawing money. This is one of the benefits of a tax-free savings account.
Tax Free Savings Account (TFSA) Rules
With an RRSP, there are a lot of rules. You might even call an RRSP the ugly stepsister of Canadian savings plans, with all its dictates and penalties for withdrawing money. On the other hand, TFSA has relatively few restrictions.
Here are the key differences:
- Withdrawals: With an RRSP, if you need to withdraw money you will face a withholding tax. Depending on the amount of the withdrawal, this could range from 10 to 30 percent. When you take money out of your TFSA, there is no tax withholding. You withdraw $1,000 and you get $1,000 in your pocket.
- Tax return: With a TFSA, you don’t need to report your contributions or withdrawals on your tax return. That’s very different from an RRSP – where you get a tax deduction for your contribution and must report any withdrawals as taxable income.
- Contribution limit: You can contribute a maximum of $6,000 per year to your TFSA. In addition, if you have not put in the maximum amount in past years, your contribution room accumulates.
Tax Free Savings Account (TFSA) Advantages
As we have indicated, the TFSA is a great savings vehicle so that are plenty of pros. The main TFSA benefits are:
- Tax free: Like its name says, the TFSA is tax free. When your investment grows, you don’t face any tax on dividends or capital gains. And when you decide to withdraw funds, there is no tax on the withdrawal. This is different from an RRSP – while your RRSP investment gains are not taxed while they are held in the account, you do have to pay income tax when you eventually retire and make withdrawals.
- TFSA goes forever: With an RRSP, you must begin tapping the funds no later than Dec. 31 of the year you turn 71. There are minimal withdrawal requirements for each year, depending on your age. On the other hand, you are not forced to withdraw money from your TFSA – ever. If you choose to keep the money in your account, you can pass it on to your heirs when you die. It’s important to name a beneficiary or a “successor holder”, such as your spouse.
- Your TFSA doesn’t affect other government benefits: Some government benefits, such as Old Age Security and the Guaranteed Income Supplement, can be “clawed back” if your income is too high. However, your TFSA will not have any impact on this since you don’t have to report any withdrawals on your tax returns. It is not counted as income. Similarly, your TFSA withdrawals will not change your Employment Insurance benefits or Canada Child Benefit.
- It’s not based on your income: Everyone in Canada has the same contribution room each year – currently $6,000 per year. Even if you have very little income, you can still make a contribution. With an RRSP, you are only allowed to contribute 18 percent of your earned income from the previous year (with a maximum of $27,830). So TFSA accounts are ideal for people with modest incomes.
- Easy to withdraw money: When you want to withdraw money, you simply fill out a form with your financial institution or investment advisor. As we have indicated, there is no tax withholding. (Some people argue that it’s too easy to withdraw money, hurting your ability to save money and grow your investments).
- Contribution room keeps growing: You can contribute up to $6,000 per year. As well, if you have not made the full contribution in past years, any unused contribution room will be added to your total. For example, if you turned 18 and opened a TFSA in 2020 but only put in $1,000 you would have $11,000 in room in 2021 (two years at $,6000 each less your $1,000 contribution).
- Many investment options: You can invest your TFSA funds in a wide range of vehicles, depending on your tolerance for risk and your financial goals. This can include stocks, bonds, cash, mutual funds and index funds. However, if you decide to invest in US equities be aware that there is a withholding tax on US dividends.
Tax Free Savings Account (TFSA) Disadvantages
As you can see from the list above, there are a lot of advantages to having a TFSA. There are some cons, although they are relatively minor:
- Contributions are not tax deductible: When you put money into your RRSP, you receive a tax credit that reduces your income tax owing. With a TFSA, you do not get any tax break. So, if one of your key objectives is to cut your income tax bill, the RRSP would be the better choice.
- No grace for overcontributions: Be careful not to put in more than your contribution limit. If you do, you will face a tax penalty of 1 percent per month. This is different from RRSPs, which offer a one-time overcontribution allowance of $2,000.
- Not protected from creditors: If you owe money, your TFSA holdings can be seized by your creditors. Your RRSP accounts are protected from creditors.
Should you invest in a Tax Free Savings Account (TFSA)?
Ideally, you should invest in both a TFSA and RRSP. Your choice will depend on your income and financial goals. Good luck!