Tax Free Savings Accounts (TFSA), rival RRSPs as a a good, tax-free way to sock away cash.
Every so often, the government gives you a tax break. It doesn’t happen very often, so it’s all the more reason to take advantage of it when it comes your way.
In 2009, Ottawa introduced the Tax Free Savings Account (TFSA) and while there has been some recent confusion about the rules, these savings accounts are a good way to sock away cash.
Here are 10 things you need to know about the tax free savings account.
1. How do they work?
The TFSA was launched in January, 2009 and can be defined by what it is not.
Unlike an Registered Retirement Savings Plan (RRSP) the contributions are not tax-deductible. So you deposit after-tax cash into it, but you can withdraw it tax free. Putting money in RRSP savings accounts gives a tax deduction when you deposit it, but you later pay tax on what you take out. So a tax free savings account as the name suggests, a tax free savings haven rather than a tax-deferred shelter like an RRSP.
2. Forever tax free
You never pay tax on the money inside your tax free savings account, so you can invest in interest bearing options like bond funds and GICs, or aim for growth in the form of investments like common stocks. You can’t deduct the interest if you borrow money to invest in your tax free savings account, but the other benefits are attractive. When you take it out, it’s still tax free and it won’t affect your eligibility for income support programs based on earning levels.
3. What can go inside
Generally the investments allowed in a tax free savings account are similar to those of the other plans and include everything from GICs to mortgages. In addition to making cash deposits to buy investments, you can make in-kind contributions by transferring shares and mutual funds you already own into a TFSA. The rule is that the investment must be arm’s length from you (for example, personal debt is not allowed) You must set one up through a financial institution, but you can make it a self-directed account and manage it on your own.
4. Beware of over contributing.
You are allowed to contribute $5,000 a year and carry forward the unused portion to the next year. But be careful. Many Canadians have been confused by the rules and face penalties as a result. They withdrew money from their tax free savings account in say January and then put the amount back in
June. They were shocked to discover that the redeposit was considered a double payment and subject to a hefty tax penalty.
5. Save and save some more
If you need spending money, go ahead and dip in. The chunk you take out gives you equal contribution room the next year. So if you remove $3,000 for a vacation, you can contribute that same amount (in addition to $5,000 maximum) the following year for tax free savings. Just be careful not to reinvest during the same calendar year. See above.
6. Contributions carried forward
You can take advantage of your unused portions of the $5,000 annual limit at any time in your life. You may be one of those people who starts saving early (you have to be over 18 years old), even when you don’t have an income that allows you to save the maximum annual amount. With a tax free savings account you can be rewarded for procrastinating by catching up on the contributions later on. There is no upper age limit for TFSA contributions, unlike RRSPs that require you to stop adding to the fund at age 71.
7. Give a TSFA as a gift
Go ahead and surprise him or her with the gift of a TFSA contribution. While this doesn’t get you any tax benefits in return, neither does it affect your own contribution maximum. And hey, it lasts longer than flowers. Also, your spouse can be the beneficiary of your plan after your death.
8. Compounding power
Investment advisors love the charts that show you how by putting away a few dollars a month for a lifetime, you could be rolling in dough, unlike your colleagues who spent it on lattes. So starting early with tax free savings and being disciplined has its advantages.
9. Canadian residents only
Non-residents of Canada aren’t eligible to open a TFSA. If you happen to leave the country after you have started a tax free savings account, you can maintain your existing TFSA, but you can’t add anything to it as long as you’re a non-resident.
Since you can’t claim capital losses in your TFSA on investments that have gone sour, it is best to opt for blue chip equities with high-yield dividends to fill up your TFSA. Also, because the maximum annual contribution isn’t high enough to spread your market exposure around, it makes sense to choose investments such as exchange-traded funds that represent a broad sample of companies found in a stock market index.
Susan Down is a Toronto freelance writer. This article was commissioned for the launch of Moneyville.ca.