What are you saving or investing for down the road? Maybe you’re thinking ahead and planning for retirement. Or perhaps you see yourself saving up to purchase a vacation home or income property, or setting something aside for your grandchildren – without dipping into your retirement income.
Regardless of your goals (long- or short-term), this article is designed to bring clarity to the advantages of a TFSA (Tax-Free Savings Account). If you’re not sure where to begin, having a conversation with a financial professional can help you understand how a TFSA can be designed to specifically help you reach your unique goals.First, a few facts about TFSAs
You may be surprised to know that an overwhelming number of Canadians don’t actually know how a TFSA works*; many aren’t even aware that a TFSA can hold investments that, when tucked away, can provide sizeable growth opportunities.The basics behind a TFSA:
- Introduced in 2009, the TFSA is a type of registered savings account.
- Any income you earn inside a TFSA is tax-free**; this includes interest, dividends and capital gains.
- Withdrawals can be made from your TFSA at any time, also tax-free**.
- Anyone who is the age of majority or older and a Canadian resident with a valid Social Insurance Number (SIN) can open a TFSA.
- You don’t need to be earning an income to invest – for example, stay-at-home parents and students are welcome to open a TFSA.
It might be wise to consider a TFSA as a way to provide yourself with an additional source of income, tax-free** – especially if you’ve contributed the maximum to your RRSP (Registered Retirement Savings Plan). When you are over 71 and can no longer contribute to your RRSP, your TFSA is a good place to continue to invest and grow your income, tax-free**. Unlike an RRSP, a TFSA doesn’t have to be converted to a RRIF (Registered Retirement Income Fund) at age 71.Investing to maximize the return on your TFSA
Within a TFSA, you can hold a variety of investments which can help you maximize the long-term benefits of your account. Many people look to invest in mutual funds, GICs (including market-linked GICs), ETFs (exchange traded funds) and/or stocks – all are options for people who can wait to benefit from the profits their TFSAs produce over time.
You might consider putting cash into your TFSA, but that should be more for your short-term savings goals because cash investments may not provide the returns you need to meet your financial goals. That said, cash could come in handy when you’re retired.Consider these investment options:
Mutual funds: With literally thousands to choose from, you’re sure to find a fund to best suit your needs. If you have any uncertainty, an advisor can help highlight the specific benefits of each fund and how each can help you reach your goals. But first you’ll need to determine how much risk you’re willing to take with your investment over the long term. If you’re of the “slow and steady wins the race” mindset, you might choose more conservative mutual funds. If your risk tolerance is higher, you can explore funds that offer potentially higher growth.
Exchange Traded Funds (ETFs). An ETF is a fund that is listed and traded on a stock exchange, consisting of a basket of securities that may hold stocks, bonds or other assets such as commodities. ETFs offer potentially lower risk than individual securities. You can purchase ETFs through ETF-based mutual funds sold at your bank, or simply by holding ETFs within your TFSA.
Guaranteed Investment Certificate (GIC): GICs offer a low-risk, guaranteed rate of return over a fixed time. Another option is market-linked GICs, where you can participate in the growth potential of the stock market with no risk to your principal investment.
Individual stocks: As investors look to expand their options, the opportunities for people to explore stocks is growing significantly. Again, your risk tolerance will determine your choices, as individual stocks can carry more risk than investments such as mutual funds might. So it’s wise to research the stocks you are investing in, making certain that you consider the benefits of diversification. If you’re not sure how to invest or what to invest in, you can seek the help of an advisor. Or, if you are a savvy investor, you might decide to research and purchase stocks (and other investment vehicles) through self-directed investing platforms.Long-term advantages of having a TFSA
Minimizing clawbacks on benefits when you retire
Here’s something else to consider: when you retire, your withdrawals from your RRSP or RRIF could potentially place you in a higher income tax bracket and may result in clawbacks of your government income-tested benefits and credits, such as the Guaranteed Income Supplement or Old Age Security. With a TFSA, your entitlement to income-tested benefits and credits won’t be affected since withdrawals from your TFSA are not included in your income for tax purposes.
Of course, an RRSP gives you an upfront tax deduction (which you don’t get with a TFSA), but remember that income tax will be payable on any amounts withdrawn from your RRSP or RRIF, usually after retirement.
Ultimately, it’s all about finding an approach that best suits your goals, one that potentially sees your TFSA complementing your RRSP by working in tandem towards achieving your savings goals.Something to watch out for
TFSAs only have so much contribution room each year
The rules regarding the ability to withdraw and re-contribute money to your TFSA are cumbersome and many individuals inadvertently run afoul of these rules. If you withdraw money from your TFSA in a year, you can recontribute it in that same year, but only if you have contribution room available. If not, you will have to wait until the next calendar year. This is because any amount contributed or re-contributed within the same year is considered a new deposit subject to the current yearly maximum contribution limit and your available contribution room. If you contribute or re-contribute an amount during the same year and exceed your available contribution room for the year, you’ll be subject to a tax each month on the amount of the over-contribution.
Let’s look at an example. Kristina opened her TFSA in 2011 and has contributed the maximum dollar limit every year since. That gives Kristina a total of $36,500 of contributions in her TFSA account by the end of 2016. When 2017 comes, she contributes $5,500, the top dollar limit for that year. Suddenly, Kristina sees the opportunity for the trip of a lifetime, so she withdraws $3,000 to travel. Then, just as suddenly, she discovers she can’t go.
She simply can’t put that money back into her TFSA. Because she’s already maxed out her TFSA contribution for 2017, Kristina will need to wait until the beginning of 2018 to recontribute all or part of the $3,000 she withdrew (which will be added to her TFSA contribution room at the beginning of 2018). If she goes ahead and recontributes before that, she’ll have an excess amount in her TFSA. That means she’ll be charged a tax equal to 1% of the highest excess TFSA amount, for each month that excess remains in her TFSA.
This article has probably already given you a lot to think about. If you’d like to ask questions or know more, feel free to get in touch with a BMO investment professional at 1-800-665-7700. You can also book an appointment. We’re here to help.
** Subject to transaction limits and to the Terms and Conditions of the chosen investment. For further reading, visit the CRA website.
*** For information purposes only. Refer to the Canada Revenue Agency website for more details. Speak to a tax professional for tax planning and estate advice.