What is a TFSA?
If you live in Canada and you have not started to contribute toward your TFSA, you should start thinking about doing so!
What is a TFSA? A TFSA (Tax Free Savings Account) is a special type of investment account that allows your savings to grow tax-free. It is similar to the Roth 401K account that is available in the United States. You deposit your money in the account with after-tax dollars, and once your money is in the account, you do not pay taxes on growth within the account, nor do you pay taxes on withdrawals.
One common point of confusion among Canadians is that TFSAs (and RRSPs (Registered Retirement Savings Plans) for that matter) are often understood to be special types of investments that you “purchase”. They are not. They are account types, in which you can hold any investment of your choice that is available within the account.
For example, you can have a TFSA at a brokerage that holds 500 shares of Apple, and a non-registered account at the same brokerage that holds another 500 shares. The difference between the accounts is in the tax treatment.
How does it work?
You deposit a lump sum into your TFSA using after-tax income. Once your money is in the account, it will grow tax-free, and withdrawals will also be tax-free.
Every year, you get a limit of $5,000 to contribute toward a TFSA. Any unused contribution room will be carried forward into the next year. In the future, these limits will be adjusted by the official rate of inflation in $500 increments.
If you are young, TFSAs offer a great option to grow your savings tax-free and take advantage of long-term compound growth. Even if you aren’t young, they are a great way to start sheltering some of your savings by providing a tax-free avenue to income and growth. They are a great complement to RRSPs for savings and investment. Any Canadian tax software package should have options regarding TFSAs.
The main drawback is that you have to contribute with after-tax dollars, as opposed to the RRSP which gives a tax rebate on deposit, and also grows tax free, but incurs a tax penalty upon later withdrawal.
One thing to keep in mind as well is that if you withdraw from your TFSA, you get back that contribution room, but you cannot re-use it in the same year. You have to wait until the following year before you are able to re-use that contribution room.
From the government’s point of view, the main drawback is that these accounts will lead to lower taxable income over time. I have read articles by some journalists who were against the idea of a TFSA as they feel that it would weaken the ability of the state to redistribute income. It is always possible that the government will renege on the TFSA at some point in the future, and people will be forced to pay large sums of taxes as penalties.
I am currently investing the maximum into my RRSPs and TFSAs, but RRSPs first. What is left I put into the TFSAs. I did not have enough income to max out my TFSA room last year, so I was able to carry over the unused contribution room over into this year. I don’t think I will max it out this year, either, but next year is looking much better. I will have plenty of room next year in which to contribute. This is great, because it will give me a lot of additional room to protect my savings from future taxes!
So, reader, are you taking advantage of your TFSA or Roth 401K contribution room? How do you feel about the effects that these type of accounts have on the ability of the government to tax and redistribute wealth and income? As always, I look forward to reading your comments.