A few months ago, I wrote about the Millennial’s Ultimate RRSP Guide where I outlined how millennials should use their RRSP. While RRSP is a very powerful tool for retirement savings, I believe most millennials will actually benefit more from the Tax Free Savings Account (TFSA). Even though TFSA is a very simple savings account, there seems to be a lot of confusions over TFSA. Statistics show that many Canadians aren’t utilizing TFSA to its full potential. Therefore, I have decided to put together this millennial’s ultimate TFSA guide. My intention for this millennial’s ultimate TFSA guide is to help Canadians, especially young Canadians, understand the TFSA better.
What is the TFSA
The Tax Free Savings Account was introduced in 2008 by the late Jim Flaherty and came into effect on January 1, 2009. It is a tax-advantage account available to individual who are 18 or older with a valid social insurance number to set money aside to grow tax-free throughout their lifetime. You make contribution to the TFSA with after-tax dollars. Unlike the RRSP, there is no income tax deduction with the TFSA. However, there are no complicated withdrawal rules and strategies involved with the TFSA. Contributions as well as any growth generated in the account are tax-free when you withdraw from the TFSA.
TFSA Contribution Guideline
- Each year there is a set TFSA contribution limit. This limit is indexed to the rate of inflation.
- You don’t need to earn an income to be eligible for TFSA. If you are 18 and a Canadian citizen or a permanent resident, you can contribute to the TFSA.
- Your contribution allowance can be carried forward to later years. So if you didn’t save enough money this year, you can contribute in future years.
- You can have as many TFSA accounts with different financial institutions as you want but the yearly contribution limit is cumulative. A word of caution, if you have TFSA accounts with multiple financial institutions, make sure to track your contributions closely. This is one of the ways to easily over contribute to your TFSA.
- Contributions to the TFSA are made with after-tax money. Therefore, there’s no income tax deduction.
- You can transfer TFSA from a financial institution to another but make sure you do a registered transfer and not a withdraw-then-transfer. Make sure to watch out for transfer fees.
- You can check your available TFSA contribution allowance on CRA’s My Account.
TFSA Contribution Limits
Here are the yearly contribution limits since 2009. If you were 18 in 2009, you have an accumulated contribution allowance of $52,000.
|Years||TFSA Annual Limit||Cumulative Total|
What Can I Invest in my TFSA?
For the average person, most investments can be held in the TFSA including:
- Mutual Funds
- Option contracts
- Investment grade gold & silver bullion
- Shares of small business corporations
Since the idea is to have your contribution growing tax-free, it is not advised to “invest” in cash or buy GIC’s. Simply put, in the current low interest rate environment, you will end up losing purchasing power if you hold contributions in cash or in GIC’s. Don’t be one of the 65% Canadians that only hold cash in their TFSA! Rather than seeing the TFSA as a short-term savings account, I like to treat the TFSA as another savings vehicle for retirement. That’s why I invest in stocks and ETFs in our TFSA.
TFSA Withdraw Rules & Limitations
- You can withdraw from your TFSA anytime.
- Money withdrawn from a TFSA is not considered as taxable income. In other words, there’s no income tax implication. This makes the TFSA a powerful retirement savings vehicle.
- When you make a withdrawal, the amount you withdrew is added to your contribution room at the beginning of the next calendar year. So if you withdrew $5,000 in 2016, you can contribute an additional $5,000 in January 1st, 2017. Make sure you don’t contribute the $5,000 in 2016 as this will count as a new contribution and may put you over your allowed contribution limit.
When Should You Not Contribute to a TFSA?
In my opinion, it is always a good idea to contribute to a TFSA. For millennials, generally they will see a bigger tax-advantage by contributing to the TFSA rather than the RRSP. Obviously this may change depending on how much income you are earning. The rule of thumb is, if you are in the lower income tax bracket, it is better to contribute to the TFSA rather than the RRSP.
What Happens If I Over Contributed to my TFSA?
I have never in a million year thought that we would over contribute to the TFSA. But it did happen to Mrs. T as we made a honest calculation mistake. Apparently in 2012 tax year CRA sent notices to about 74,000 taxpayers about TFSA over contributions. So people do accidentally over contribute to their TFSA. What happens when you over contribute?
- You will receive an excess amount letter from the CRA stating TFSA over contribution
- TFSA over contribution penalty is 1% per month on the amount of the over contribution. If the CRA thinks the over contribution was done deliberately, steeper penalties could be imposed.
- If you receive an excess amount letter, immediately remove the excess amount and write a cheque to CRA with the penalty amount. You can also ask CRA for forgiveness and to waive the penalty amount.
- Here’s more info on our TFSA over contribution and what we did to ask for forgiveness.
How You Should Use the TFSA
Unfortunately, many people simply view and use the TFSA as an account for short term saving and an emergency fund. I strongly disagree with this simplistic view. The biggest advantage for the TFSA is the ability to grow your contribution tax-free. Any TFSA withdrawals are tax-free. So why would you leave your TFSA contribution grow at a lousy 0.5% when you can invest it in equity and let it grow at the historical stock return rate of 7%? Let’s put this in a quantitative way… Assuming you have $52,000 sitting in your TFSA and make no further contributions in the future.
- At 0.5% growth rate, in 30 years you will end up with a jaw-dropping $60,392.80.
- If you invest your $52,000 in stocks, at the historical return of 7%, you will end up with $395,837.26 after 30 years! A $343,837.26 tax free income! Talk about the power of compound interest!
Now which one wold you rather have? A cool $60k in your TFSA after 30 years, or a ridiculous-uber-cool-Bob’s-your-uncle $343k? I don’t know about you, I’ll take the $343k any day. Having said all that, depending on your situation, investing 100% of your TFSA contribution may not be the best approach. Here are a few questions you need to ask yourself:
- Do you need the funds in the short term? If you foresee the need to withdraw from the TFSA, perhaps investing in GIC’s or money-market funds makes sense.
- What is your risk tolerance level? Depending on your risk tolerance level, 100% in equities might not be the right choice. Perhaps a 50-50 mix of stocks and bonds? Or perhaps 70% in stocks and 30% in GIC’s?
- Do you have extra contribution room? If you have extra contribution room, consider moving your emergency fund (here’s why we don’t have one) or other big savings so they can grow interest free.
- Should you transfer your TFSA to a RRSP? Depending on your income situation, it may be beneficial to transfer money from a TFSA to a RRSP. This will give you immediate income tax deductions. Remember that any TFSA withdrawal amount is added to your contribution allowance in the new year. This may be an effective way to maximize tax deduction. Please consult a tax specialist if you are considering this approach.
My TFSA Story and Plans
- Since 2009 I have maximized my TFSA contribution every year.
- Originally I left my TFSA contribution with ING Direct (now Tangerine) in GIC’s, earning a low interest rate.
- When I learned more about stock investing and dividend growth investing, I transferred my TFSA from ING Direct to TD Waterhouse and started investing in stocks.
- When Mrs. T became a Canadian permanent resident in 2011, we right away started contributing to her TFSA.
- We have already maximized our TFSA contribution allowance for 2017. In total we have contributed $52,000 to my TFSA and $42,000 for Mrs. T.
- We consider our TFSAs as our retirement savings vehicles. In other words, there’s no plan to withdraw our TFSA contributions anytime soon. We plan to use dividend income from our TFSA (tax-free booya!) to fund part of our expenses when we are financially independent.
Note: Unlike RRSP, TFSA aren’t exempt from the US 15% dividend withholding tax. So if you invest in US dividend paying stocks inside TFSA, you’ll get hit 15% every time you get dividend income. Best to invest US dividend paying stocks inside your RRSP. What do you think about this millennial’s ultimate TFSA guide? Did I miss anything? Do you have any other tips I should include?