What is a TFSA?
A Tax-Free Savings Account (TFSA) is an investment account that allows for all of the money you make with it to be tax-free.
The mighty Tax-Free Savings Account in Canada is one of the most powerful investment accounts in the world. Any money you make on stocks, bonds, and mutual funds using this account are completely tax-free.
Let that sink in for the moment. This is one of the very few cases where the government doesn’t tax you for making money.
We’re going to get into how the TFSA came about, explain how it works, and make some suggestions on how to maximize your earnings from your TFSA.
How the TFSA came to be
The TFSA was modeled after the Investment Savings Account (ISA) in Britain. The TFSA is one of the few tools in any advanced economy to offer this insane level of tax protection for investments. This is a very good thing considering how much taxes Canadians already pay.
The USA has something similar to the Canadian TFSA, in the form of the Roth Individual Retirement Account (Roth IRA). However, the Roth IRA has way more restrictions on what you can hold as an investment – making it far less powerful than the TFSA.
The TFSA started in 2009 under the Canadian Government led by Prime Minister Stephen Harper. The goal was to incentive Canadians to start saving more money as household debt levels were rising.
Now over 80% of Canadians over 18 years old have TFSA accounts with almost a trillion dollars cumulatively invested.
So how does the TFSA work? Even though the TFSA is an amazing vehicle to carry your investments, there are some rules you need to follow. The list below has everything you need to get started.
- Starting at 18 you get a certain amount of contribution room. You accumulate TFSA contribution room each year after you turn 18 (even if you’re not filing income taxes yet). We will go over the particulars of contribution room in the next section of this article.
- Any money you make from your investments are tax-free. So if you buy a stock for $1 and it rockets to $100,000,000 a share and you become a billionaire, you don’t have to pay taxes on any of it. There is no limit on how much you can make tax-free. Amazing.
- There is no age limit on how old you can be to contribute, and if you do not use the room it keeps carrying forward forever.
- You cannot claim losses in a TFSA. So if you lose money in a TFSA it’s worse than if you lost money in an unsheltered investment account since you can’t write it off against your other income.
- You can withdraw any amount you want from your TFSA at any time without penalty. However, any TFSA withdrawl does not increase your contribution room until the next calendar year. This peculiarity gets some people so here’s an example of how this works.
Sometime in 2021 the value of your shares go to $100K due to the success of Tesla. You also have $6,000 worth of room for 2021 as set by the government.
In 2021 you sell the shares and pull out the $100K from your TFSA. This amount is tax-free and does not even have to be reported. You can do whatever you want with it.
However, if you then put the $100K back into your TFSA then you will incur a penalty since you only had $6,000 worth of contribution room. Again, the money you take out of your TFSA does not increase your contribution room until the next calendar year
However, if you wait until 2022 then you will have $6,000 of unused contribution room carried forward from 2021, another $6,000 for 2022, and $100,000 carried forward from the withdrawal 2021. So in 2022 you will have $6,000 + $6,000 + $100,000 = $112,000 of contribution room.
If you accidentally over-contribute to your TFSA, the government has the right to penalize you to the tune of 1% per month on the excessive amount.
Got it? Good!
TFSA Contribution Limits
So now you’re familiar with the basic rules of your TFSA account, the next question is how much you’re actually allowed to put into it?
The easiest way to find out is to log into your Canada Revenue Agency (CRA) account and see. They keep track of all of this for you.
If you don’t have access to an online CRA account (get one!), here is how much contribution room you gain yearly from the government.
- 2009 to 2012: $5,000 per year
- 2013 to 2014: $5,500 per year
- 2015: $10,000 per year
- 2016 to 2018: $5,500 per year
- 2019 onward: $6,000 per year
Here’s an example to help illustrate how this works.
Let’s say you turned 18 in 2016, and it is now sometime in 2020, and you’ve never contributed to a TFSA.
You now have $5,500 (2016) + $5,500 (2017) + $5,500 (2018) + $6,000 (2019) + $6,000 (2020) = $28,500 of room in 2020.
As you can see from the example above, your TFSA room accumulates every year even if you don’t have a TFSA investment account open. The government tracks this for you via your social insurance number, and financial institutions automatically report any TFSA account you open so you don’t have to do any reporting on your end.
Investment income earned by, and changes in the value of TFSA investments will not affect your TFSA contribution room for the current or future years. It doesn’t matter if you made $1 or $1,000,000 in your TFSA last year – the government will still give you the same contribution room increase. If you don’t use the room, it accumulates indefinitely.
The government’s formula to calculate your contribution room is:
This year’s contribution room = (A) unused contribution room carried forward from last year + (B) contribution room provided by the government for this year + (C) total withdrawals from last year.
From the formula above, you can see that any withdrawals you make will increase your contribution room. So if you invest early and make a bunch of money, then you can withdraw that amount from your TFSA to increase your contribution room for the future!
How to Maximize Earnings from Your TFSA
As we mentioned before, any investment losses you incur in a TFSA is not tax deductible. This makes losing money in a TFSA much worse than losing money in a normal investment account. Because of this, we think you should be more conservative than usual with your TFSA investments.
- Lean heavily towards index funds and bond funds – or their ETF equivalents. For a sample investment allocation that is conservative check out this article.
- If you feel the itch to gamble on a stock, then make sure it’s less than 10% of your TFSA investment portfolio. We get it. Sometimes you just believe in a stock, and will feel like an idiot if you don’t at least give it a shot. Just make sure that even if you lose all of the money you toss at an individual stock you will still be okay since 90% of your money are in index funds and bond funds.
- Max out your TFSA before your RRSP – especially if you’re young. Remember, any money you make is tax-free. So if you have years and years of compounding returns in a TFSA this becomes very powerful. Especially when you retire and start to withdraw money from the account without having to pay any taxes. With RRSP’s, you have to pay taxes on the money you take out of it.