This week, we'll be discussing the Tax-Free Savings Account (TFSA), one of my favourite types of accounts. The most flexible out of all the registered accounts and most commonly used. Despite its popularity, the TFSA isn't used by some to its full potential. I'll help you understand it so you will end up keeping more money for yourself.
People are using it as a savings account when it should be used as an investment account. It's such a waste because if invested properly, you could be seeing significant returns without the need to pay any taxes. Your TFSA should not be used to store your emergency funds. That's a job for your regular savings account. There are lots of annoying rules that you need to know so I'll do my best to simplify everything and provide clarity.
How Does It Work?
The year you turn 18, you may open a TFSA. Every year since 2009, the government announces a new contribution room for your TFSA. It's important to understand your contribution room so you don't overcontribute and get penalized. The penalty for overcontribution is 1% on the excess amount for each month you are over. Your TFSA's contribution room starts the year you turn 18 and continues to add up afterwards. You do not get any contribution room for the previous years you were under the age of 18. Refer to the chart below to find your total accumulated contribution room.
You're probably confused. Let me explain with an example:
- Larry (age 20)
- Current Year: 2020
Larry is currently 20 years old, so that means he turned 18 in 2018. His TFSA contribution room started in 2018. Now we just add up the amount for the years he was age 18 and over. Larry does not get any contribution room for the years 2017 and under because he was under the age of 18.
Another important rule to remember about TFSAs is if you withdraw, you can't re-deposit it back until next year unless you have room. Let me explain with another example:
- TFSA 2020 Limit: $6,000
- Deposit in 2020: $6,000
- Withdraw in 2020: $4,000
2020 remaining TFSA contribution room: $6,000 - $6,000 = $0
2021 TFSA contribution room: $4,000 + (new government limit)
Upon Death
You've heard this before but taxes and death are the only guarantees in life. This is also important to understand as it relates to estate planning but you may name beneficiaries for your TFSA. This means when you die, the funds in your TFSA will be taxed and goes to the people you've named. Alternatively, if you have a spouse or common-law partner, you may name them as Successor Holder instead. In this instance, when you die, your ownership of your TFSA transfers to your partner and you can avoid paying taxes. The successor holder only applies to spouses and common laws.Rules to Remember
- Your TFSA contribution room starts the year you turn 18
- You do not get any contribution room for any year you were under the age of 18
- Any unused contribution room can be used towards future years
- You can withdraw any amount but if you withdrew from your TFSA, you are not allowed to deposit again until next year unless you have room. Depositing in the same year will count as an overcontribution unless you have enough contribution room
- You don't lose any contribution room for withdrawing
- The penalty for overcontribution on your TFSA is 1% on the excess amount for each month you are over
- You can invest in a variety of eligible investments
- Your TFSA grows tax-free and you can withdraw without paying any taxes
- Your TFSA contribution room will shrink if you sell an investment at a loss
- Your TFSA contribution room will grow if you sell an investment at a gain
- You can set your spouse as a 'successor holder' to avoid taxes upon death
Ok that's everything about TFSAs! That was a lot to cover! Take your newfound knowledge of TFSAs and put it to good use!
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