Tax-Free Savings Account (TFSA) Anatomy 101

 

Dr. Deijman’s Anatomy Lesson – Rembrandt f 1656

Alright, let’s spritz some lemon under our noses to cut the formaldehyde stench and take out our dissection kits. First on the financial anatomy table will be TFSAs.

I chose TFSAs to start this anatomy series with because it is one of the most misunderstood and misused accounts. It is also one of the most powerful if used correctly. This will be our equivalent of learning about the anatomy of the brain. So, let’s pop off the cranium and have a peak.

I was going to put some white space here so that you can scroll down in case the above picture is grossing you out. My daughter thought that some Care Bears would be better to help you think happy thoughts.

Random, I know, but I am a sucker for her ideas.

Images by Max Knoblauch

Alright, now let’s start with the gross anatomy.

TFSAs are pretty new, brought about in 2009. As a side note, Garth Turner, pack leader of the Greaterfool blog about Canadian finance, real estate, dogs, and Harleys was in government at the time. He advocated for this beauty before he ran afoul of the Harpernator.

You should thank him and also pay homage to our late elfin diety, Finance Minister Flaherty, because this is actually a very powerful retirement investment tool. The government branding was “An RRSP is primarily intended for retirement. The TFSA is like an RRSP for everything else in your life.”

Unfortunately, this branding it like a “savings account” has distracted from its retirement saving power.

Main Features:

  • Anyone over 18 can open one.
  • You accumulate contribution room each year and it varies by year depending on the Federal Government’s whim.
  • As the account grows from investment, the contribution room grows.
  • You do not pay tax on the money taken out.
  • You contribute with after-tax money.
  • The money inside grows tax-free.
  • Income you take out from this account does not count towards clawbacks of income tested government benefits like Old Age Security (OAS) or Canada Child Benefit (CCB).
  • There are a few pitfalls to be aware of.

Let’s now cut beneath the surface and examine each of these features in more detail.

How to open a TFSA

If you are over 18, you can do this at a bank or an investment brokerage. I don’t endorse any specific institution. However, generally in a self-directed investment account is the way to go – either self-directed at a discount brokerage or via your advisor’s brokerage.

There are some potential traps here:

  • Don’t get trapped into the idea that it is a “high interest savings account” (HISA) at a bank. It has been marketed that way, but what a waste. Hopefully you realize why by the end of this article.
  • Don’t get trapped into high fees with a Mutual Fund TFSA. The mutual fund active management fees will likely be a drag on the growth of your TFSA compared to passive ETF investing.

Banks profit from the HISA and mutual funds. So, they will likely be the first options promoted if you go there.

What you can have in your TFSA

A TFSA can hold anything that an RRSP can hold. This includes cash of any currency, equities, bonds, trusts, preferred shares, and certain debt obligations.

How to figure out your contribution room

The room has varied by year as per the table below. You also get more room if you have grown your investments in the account, dollar for dollar.

Annual TFSA Contribution Room

YearContribution RoomTotal Room if >18Y in 2009
2009-2012$5000/yr$20000
2013-2014$5500/yr$31000
2015$10000$41000
2016-2017$5500/yr$52000

The above table gives your room based on not having contributed anything to this point. To find out your actual room accounting for your previous contributions and withdrawals, you can look on your Notice of Assessment from the CRA that you get after doing your taxes each year or you can use the My CRA Tool.

The power of the TFSA – Don’t squander it!

TFSA strategies
“With great power comes great responsibility” – Spiderman, seen here with NYC Mayor Mike Bloomberg.

The TFSA is powerful because the money grows tax-free and you do not pay tax on it when you take money out.

If you use it for short-term savings like for your next vacation, car, or gold-plated diamond-encrusted iPhone X, then you aren’t going to let it grow with the power of compound returns. That short-term use also requires a short-term stable interest-bearing investment like a [gasp] HISA that earns a laughable 1.3% interest rate. Putting GICs in it is not really any better while in your wealth building years. That may even be worse due to illiquidity. You will never grow your TFSA like that. Once you have grown a large TFSA and need the space for stable fixed income, it may be time to make that switch

But, but, but a GIC is garaunteed!! Yes, it is guaranteed to return about the rate of inflation. In the words of another Garth… HISA/GICs for TFSA = Looooozzzzzzzzrrrrrrrrrr Garth should shock you with his tazer.

 

The power of a TFSA is harnessed by using it to invest in things that you leave in there to grow over a long period. That could be equities for maximal growth. There are lots of different specific strategies with pros/cons depending on how it fits into your overall income level and investment/tax plan. That is the topic for a more advanced post.

Let’s look at a simple example.

You are 40, a reasonable saver, and have put the maximum $52K in your TFSA. However, you were a loser until Garth tazered you and broke you from your stupor. With your reset brain, you invest it plus $5500 each year in a balanced 60/40 equity/bond split in your TFSA. That would be expected to return ~8%/yr historically.

When you turn 65, you retire and now have ~$800K in your TFSA. At a safe withdrawal rate of 4%/yr it would give you ~ $32K/yr in tax-free income. If you are married and your spouse does the same – double it!

Now, let’s also say you also invested in other retirement vehicles or a pension and also get $74000/yr in taxable retirement income. You also get Old Age Security (OAS) of $7K/yr. Your TFSA money does not count towards the OAS clawback.

That’s right, you can have a retirement income of >$100K/yr and still get the full government old-age welfare benefit!!!!!

It would feel really good to give that little poke in the government eye after a lifetime of paying a high marginal rate of taxation with exclusion from any income-tested benefits, wouldn’t it?

TFSA benefits

Now, anytime we are doing something that could poke our dark overlord in the eye, we need to be aware of potential pitfalls. They are readily avoided if you know about them.

If you take money out of a TFSA, then you must wait until the next calendar year before putting it back in.

For example, if you currently have $25K in your TFSA and $2K of contribution room for this year and you take out $10K:

  • You could put $2K back in this year (from your unused contribution room), but you cannot put more back in until the new calendar year.
  • In the new calendar year, your contribution room would be $10K (for the money you took out) plus $5500 (the annual increase) for a total allowable contribution of $15500.
  • If you put the money in prior to the next calendar year, you pay a 1%/month penalty on the amount of the over-contribution

If you make frequent trades in your TFSA and profit at it, you could get whacked.

  • CRA has audited people with large TFSAs. If you are using it like a day trader would, then that is considered employment income rather than saving.
  • They would then tax it at your marginal rate (ouch).
  • Of course, if you day trade and lose money at it, there is not penalty since you are already punishing yourself.
  • This is another reason to use a more passive buy and hold strategy with rebalancing as needed.

If you have US dividend paying equities in your TFSA, you will pay a 15% withholding tax on dividends. Non-US foreign dividends are similarly punished.

  • The US government treaty does not consider the TFSA a pension, so will not exempt if from the tax. Since you do not get T3s or T5s for a tax-sheltered account, you cannot recover the foreign withholding taxes like you would in a non-registered investment account.

The TFSA is one of the most powerful weapons in our quest for FI arsenal.

  • The most recent tax and spend government immediately cut back the TFSA space when elected. This was certainly to reduce revenue loss, but was billed as “only rich people can put money into a TFSA and benefit. So, it doesn’t benefit the middle class”.
  • TFSAs are indeed grossly under-utilized by the Canadian public. In 2015, only 1 in 5 were maximizing their TFSA. Those who do were evenly distributed across the income spectrum, so the notion that only rich people can save is not really true. High earners do save more on tax with a TFSA simply because they pay more tax – it is proportional and egalitarian – not sure why that is considered so bad. In fact, I would argue those on the lower side of the income streams can benefit the most from TFSAs.
  • While it is easier to save some money when you earn more money, it can be done on most incomes. It is a matter of prioritization as the FI community could readily tell you or as illustrated in my Lessons From the Quest for the One Ring post as an example.

For high-income earners: You should be maximizing your TFSA every year. You get TFSA room whether you are paid via salary or dividends from a CCPC. If you don’t use this gift, you need to get it together dude or dudette.

For middle-income earners: You should also be maximizing your TFSA. If you aren’t willing to make the sacrifices to maximize both your RRSP and TFSA and struggle about which to use. Consider contributing to your RRSP and then immediately taking the tax refund from that and put it into your TFSA.

For low-income earners: The TFSA is your friend. You probably do struggle to maximize both an RRSP and TFSA. An RRSPs biggest benefit is to defer tax now when you are earning more income until later when you are presumably earning less. This may not apply to you if you earn little now and pay little tax now already. Putting money to work in your TFSA can allow you to build an income that won’t get taxed now or later and won’t lead to the clawback of low income targeted benefits. While taking money out of your TFSA is not a good idea, it is much easier than if it is locked up in an RRSP.

TFSA rulesAre you maximizing your TFSA? Do I need to call Garth to come to visit you? Is your TFSA languishing in a HISA feeding the banks and the Inflation Monster? Do you know of other TFSA nuances or strategies?

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