As a Canadian, you’ve probably heard of the Tax-Free Savings Account (TFSA). The TFSA is by far the best investment account for growing wealth for most Canadians.
The TFSA is the easiest to use and most flexible investment account that you can own. I’ve written many articles about the TFSA, and I wanted to put everything that I learned into one ultimate guide for every Canadian to enjoy.
What is a TFSA
The TFSA is an account that has been available to Canadians over the age of 18 with a valid SIN number. After you fund your TFSA with money, you can then use it to purchase several different investments within your account.
The amount will grow tax-free within the account and won’t incur any interest or dividend taxes, and there is also no capital gains tax if you sell the investments. With continuous compounding over time, this can add up to a huge difference, sometimes even in the hundreds of thousands of dollars!
TFSA contribution limits
2023 TFSA limit: $6,500. One of my favourite features is that the TFSA limits are the same for every Canadian. Your income level does not matter. Since the TFSA has been around since 2009, the cumulative amount you can contribute is $88,000.
This is great because it provides every Canadian with ample room to start saving. You carry forward the unused TFSA room that you haven’t used in the previous years, so if you miss a year, don’t worry, it will be available for you still.
Yearly TFSA contribution limit table:
How to check your TFSA contribution limits
It’s essential that you get your contribution limits correct and not contribute more than you’re allowed to. Since your TFSA starts when you are 18, if you were born after 1991, you might not have the maximum listed in the table above and will need to manually calculate it.
If you’re unsure of your contribution room, the best way to find out for certain is to call the CRA at 1-800-959-8281 or log in to your account on the CRA website. This will give you an exact number that you can work with.
What type of investments can I hold in my TFSA
The TFSA is very versatile and can contain several different investments, including the following:
- Securities are listed on a designated stock exchange – for example, stocks traded on the TSX exchange.
- Guaranteed investment certificates (GIC)
- Mutual funds
- Certain shares of small business corporations
A notable absence from this list is land and real estate. You can’t hold real estate investments, such as land deals inside of your TFSA.
What should I invest in my TFSA
In my opinion, the best investments to hold in a TFSA should provide strong growth potential, beat inflation, and have low fees. Here are three of my investing principles when it comes to my TFSA:
- Exchange-traded funds (ETFs) and stocks are my preferred investments for a TFSA since all of the accumulated dividends, capital gains, and interest income grow tax-free within your TFSA. There are also very low fees for holding each of these investments.
- I don’t invest in mutual funds, as Canadian mutual funds are known to have some of the highest fees in the world. A recent study by Barrons showed that Canadians pay the third-highest mutual fund fees in the world. The high fees usually lead to underperformance in the long term, which is what you should be thinking about for your TFSA.
- Cash isn’t good to hold in your TFSA because interest rates are so low in Canada. It’s unlikely your investments will even beat inflation.
Penalties for overcontribution
The penalties for overcontribution are steep. For every dollar you are over the contribution limit, you will be taxed 1% every month on it. If you overcontribute, it can be easy to not notice for over a year. A $1,000 overcontribution can lead to a $120 penalty after one year.
If you have overcontributed and find yourself with a penalty, all is not lost. Try calling the CRA, as you might be able to dispute the penalty. You might have to fill out this form but talk to the CRA first to see if that is necessary.
TFSA vs RRSP
There is an endless debate on whether you should contribute to a TFSA or an RRSP. There are some general rules of thumb, such as if your income is $50,000 or less, start contributing to the TFSA first. Your marginal tax bracket is essential here.
If you are beginning to pay a very high tax rate because your income is significant, you could start to look at contributing to your RRSP. I personally like to max out my TFSA before my RRSP. The three reasons that I choose the TFSA over the RRSP:
- Simplicity – The TFSA is simple to understand and easy to figure out the contribution rooms.
- Flexibility – The RRSP is locked in until retirement, and any attempt to withdraw it will incur hefty taxes.
- Transparency – Because we don’t know exactly what tax rates will be in the future, or what our income bracket will be when we retire, its challenging to know how much taxes we will be saving in the long run with the RRSP. The TFSA does not have this problem.
- An exception is if your employer provides you with matching RRSP contributions, then always go max out your RRSP first since it is considered “free” money.
Start with the TFSA, transfer to the RRSP
There’s a trick that savvy investors can try. When you’re starting your career, it’s likely your income won’t be that high. You want to start by saving everything you can into the TFSA. When you are in a higher tax bracket, if you find yourself short on your RRSP contributions in one year, you might want to withdraw some amount from your TFSA and contribute to your RRSP. This could maximize the tax savings.
TFSA vs savings account
In my opinion, the tax-free savings account should have been named the tax-free investment account. The word “savings” has likely confused a lot of Canadians into thinking that this is all you can do with the account.
And 43% of Canadians have confirmed that they believe that the TFSA is for savings, not investments.
Your TFSA is best used when you invest in things like ETFs and stocks, and you can let the dividends and interest income grow tax-free. This can lead to astonishing gains if you can hold onto the investments over a long period.
TFSA as an emergency account
A lot of Canadians are holding cash in their TFSA and using it as an emergency account. While this is perfectly allowable, I think this is a waste of your TFSA. If you are truly in an emergency and need access to money immediately, your TFSA will not be available as it takes time to withdraw money from your TFSA.
Typically it takes a day or two to withdraw money from a TFSA, and it could be even longer depending on what investments you’re holding it in. It’s best to use something like a line of credit for emergencies and leave the TFSA for investments.
Withdrawing your TFSA
If you have to withdraw money from your TFSA, there are some important things to note. The main thing that trips up a lot of investors is if you withdraw from your TFSA, the contribution room is not available until the following year.
You must be careful not to contribute until the following year if you don’t have the room, or you might be hit with penalties.
Call the CRA about your TFSA
Got questions about your TFSA and need the most up-to-date information? The Canada Revenue Agency (CRA) is a fantastic resource if you have questions about the TFSA that you need to be answered.
Who better to ask than the people who wrote the rules about the TFSA? The wait times might be lengthy, but the advice you get is free, and you can talk to someone in person.
Common TFSA mistakes to avoid
If you overcontribute to your TFSA, you will incur a penalty of 1% of the value every month. Make sure you don’t overcontribute, and always check your TFSA contribution limit if you’re not sure.
Withdrawing TFSA and contributing in the same year
If you withdraw from your TFSA, that contribution room won’t be available until the next year. If you’re near the contribution limit, wait until the following January to contribute again to your TFSA.
Transferring between financial institutions in cash
If you transfer between financial institutions in cash, you run the risk of overcontributing to your TFSA, as that will be considered withdrawing from your TFSA.
Purchasing foreign dividend stocks
If you are buying a foreign dividend stock, such as a U.S. stock in your TFSA, the dividends are subject to a withholding tax of 15%. While the amount isn’t usually too significant, this is something you want to be wary of.
Being too conservative in your investments
A primary goal for your TFSA should be to at least beat inflation. If you’re invested too heavily into GICs or even cash in a savings account, your returns will be too low for this to happen.
Using your TFSA as an emergency account
Your TFSA takes time to move money out from the account, typically at least one business day. If it is truly an emergency, this might be too late for you.
Thinking short-term for your TFSA
Your TFSA is best used for long-term investing, where the benefits of having your investments grow tax-free start to take hold over the course over at least 5-10 years.
Not understanding how market losses impact future contribution
If you lose money on your investments in your TFSA, this does not increase the contribution room you have remaining. Instead, that contribution room is lost forever.
If you are trading excessively in your TFSA, you run the risk of the CRA slapping you with heavy penalties. The TFSA was meant for a savings and investment vehicle for Canadians, not for day traders to turn a profit.
Death of a TFSA holder
Depending on the circumstances, there might be tax implications if a TFSA holder passes away and designates a beneficiary. You will have to consult with an expert on your situation.
If you’re planning on transferring your TFSA to your spouse or common-law partner after you pass away, make sure you designate them as a successor holder and not as a beneficiary.
If you choose them as a beneficiary, it is a more complicated process, and the account may not pass entirely to them tax-free.
However, if you designate them as successor holders, it will be passed tax-free without any complications.
Marriage or common-law partnership breakdown
When there is a breakdown in a marriage or common-law partnership, an amount can be transferred directly from one individual’s TFSA to the other’s TFSA without affecting either individual’s contribution room. The transfer must be completed directly between the TFSAs by the issuer.
If you become a non-resident of Canada, you can still withdraw and buy and sell investments with the existing TFSA that you have, but you can’t contribute anymore. Your contribution limit also does not increase each year anymore.
Where to open a TFSA
There is no shortage of options when it comes to where you can open up your TFSA. You can open it up using a self-directed account like Questrade, an online investment manager such as Wealthsimple, an online bank like Tangerine or Motusbank, or a brick-and-mortar bank like RBC or Scotiabank.
You can also contact your financial institution, credit union, or insurance company.
Your TFSA is a fantastic investment tool. Make sure you know most of the rules and avoid the common pitfalls and mistakes that TFSA investors make.