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Tax Free Saving Accounts (TFSAs)
During tax season you hear a lot of acronyms being tossed about, like RRSPs and TFSAs. But what does it all mean? Do you know where and how to invest your money? Are you investing at all? You know you should be putting some money away for that rainy day, but it can be overwhelming trying to figure out which way to move if you’re not familiar with all that financial jargon. Let’s take a closer look into TFSAs—tax free savings accounts—and answer some of those common questions.
What is a TFSA ?
TFSA stands for Tax Free Saving Account, but it’s not a savings account. It’s more like a catch-all bucket that holds all your different investments, like GICs, stocks, bonds, and so on. The TFSA “bucket” can be opened by anyone over 18 years of age who holds a valid social insurance number (SIN).
Launched in 2009, the TFSA program was designed to help individuals contribute to their savings without having to pay tax on the earned interest. Unlike RRSPs, however, TFSAs are not deductible for income tax purposes, but they are accessible without penalty.
Should I open a TFSA?
Probably. Which one, though, depends on your savings goals. You could save it for retirement to supplement other income you may have from pensions or RRSPs. Or you could use it for short-term goals like buying a new car, home renovations, or taking a vacation.
The type of investment(s) you choose will be based on factors like:
- Your risk tolerance
- How many years until your retirement
- Your investment know-how
- How hands-on or hands-off you want to be in managing your portfolio
What are the benefits of a tax free savings account?
There are several benefits to having a tax free savings account. First, it allows you to invest your hard-earned money in a high-interest, tax-free account, which will help you grow your savings quicker than in a standard savings account. “Tax-free” means you won’t have to pay income tax on the money your TFSA earns, like capital gains and dividends. Also, you’re able to withdraw money from your TFSA at any time for any reason without paying a penalty.
Bonus #1: As a retiree, the money you take out from a TFSA isn’t considered income, which means it won’t affect benefits like Old Age Security (OAS).
Bonus #2: If you withdraw cash from your TFSA this year, that amount is rolled over into next year’s maximum contribution limit. So if you withdraw $3,000 this year, next year you can contribute the normal max of $5,500 plus $3,000.
What is the maximum TFSA contribution limit?
Similar to the RRSP, the maximum allowable contribution to a TFSA changes every year, so ask the CRA or check with your accountant. For example, in 2018 the annual maximum you can contribute to a TFSA is $5,500 with a cumulative limit of $57,500. There is no limit on how much your TFSAs are worth. These limits only apply to the amount of money you can put into the account.
What are TFSA withdrawal rules?
You can withdraw as much as you need or want from your TFSA at any time without paying a tax penalty. However, it’s important you pay attention to the contributions limits, as there are maximums in place for that.
When you withdraw money from your tax free savings account and then try to put the money back within the same year, it could cause your total contributions for the year to exceed the annual contribution room limit. In that case, you’ll face having to pay 1% monthly tax on the extra amount.
For example, suppose you’re allowed to contribute $5,500. If you put in $5,500 in January, then withdraw $4,000 in March to buy a used car, you can’t put that $4,000 back in until the next year because you’ve already maxed out with your January payment. If you do put that $4,000 back into the TFSA before the end of the year, you’ll have to pay 1% monthly tax on the $4,000.
The good news is that when the next year rolls around, you’re able to reinvest that $4,000 you borrowed in previous year plus the next year’s maximum—which will be $5,500 or more.
What are TFSA interest rates?
Just like every other account, interest rates vary on tax free savings accounts. The rate of return depends on the investment you purchase inside the TFSA. You can invest in your TFSA in a variety of ways, including:
- Guaranteed income certificates (GICs)
- Government and corporate bonds
- Mutual funds
- Exchange-traded funds (EFTs)
Different banks offer different interest rates. Here are some examples of interest rates being offered on TFSA high-interest savings from the major Canadian banks:
- CIBC, BMO, TD & RBC: 0.45%
- PC Financial & Tangerine & Scotiabank: 0.8%
TFSA versus RRSP
RRSP stands for Registered Retirement Savings Plan. When you contribute to an RRSP, your earnings are tax deductible—that’s the benefit. However, you’re essentially locking your money away for retirement. If you withdraw that money early, you’ll pay hefty penalty fees.
That’s not the case with the TFSA. With a tax free savings account, your contributions and investment income are tax sheltered just like the RRSP, but you can gain access to your money without penalty.
RRSP’s also allow you to deduct contributions for income tax purposes, whereas the TFSA contributions are not deductible in that way.
For example, if you earn $50,000 per year, and you contribute $5,000 to an RRSP, you’ll only pay income tax on $45,000—but you can’t touch that $5,000 until you retire, without paying penalties that is. If you put the same $5,000 into a TFSA rather than an RRSP, you’ll pay income tax on your full $50,000 income, but you’ll have penalty-free access to your $5,000 investment. In both cases, the $5,000 and investment earnings are tax sheltered.
How will you invest your money this year? A tax free savings account may be right for you.
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