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Saving on Taxes and Growing Your Wealth with the Tax Free Savings Account (TFSA)

By Kevin

Piggy Bank. Source: http://www.canlearn.ca/eng/saving/clb/brochure/clb.shtmlWhat 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.

Advantages

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.

Disadvantages

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.

My thoughts

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.

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Filed Under: Growing Your Wealth, Investing Tagged With: Canada, finance, planning, retirement, Roth 401k, savings, tax-free, taxes, TFSA, wealth

About Kevin

Kevin has left the office, and he is currently fighting the rat race by working on his own business. He enjoys exploring unvisited places around the world and gaining new experiences. He believes that by properly managing our energy and time, we can learn to invest our lives wisely.

Comments

  1. Roshawn @ Watson Inc says

    September 23, 2010 at 8:49 am

    Kevin,
    Although these types of accounts can be crucial pieces in one’s retirement, I often am concerned that people don’t know how to individualize their investments based on their retirement priorities. In terms of tax-free and tax-deferred investments preventing wealth redistribution, I don’t think of it that way. This is income that people have earned and are trying to be responsible with (invest for retirement). The tax savings is a small incentive in the scheme of things to promote good behavior. I’m sorry if some feel that taking care of your family inhibits their agenda, but their agenda is should not be our primary concerns.

    • Kevin says

      September 24, 2010 at 7:00 pm

      Roshawn, I agree with you about the agendas of those other people. Somehow, they seem to me to be the greediest and most selfish people of all, although they pretend that they are the complete opposite.

      I am curious about what you said in the beginning: “I often am concerned that people don’t know how to individualize their investments based on their retirement priorities.” I’d be interested in reading more about what you think, here.

  2. The Wealth Artisan says

    September 23, 2010 at 10:13 am

    I agree with Roshawn, social programs are important to an extent, but when people start talking about how your wise investment for your future could hinder the government’s plans for someone else’s retirement, that just sounds silly. Generally, everyone has equal opportunity to save for retirement, and if you choose to save for yours, you shouldn’t also have to save for the guy next door who isn’t thinking about the future.

    You are trying to do without $10,000.00 of your income each year so you can retire later. If other’s aren’t making the same sacrifices, then they shouldn’t reap similar benefits off of your back. That is what the charities are for. I tithe 10% of my income so that my church can help to feed and clothe the homeless, take care of windows and orphans, and provide basic necessities in the community. That is what Churches, charities and you do, should you choose to voluntarily contribute. It should never be forced.

    Thanks for such an excellent write up about these accounts!

    Thanks,
    Timothy

    • Kevin says

      September 24, 2010 at 6:58 pm

      You’d be surprised at what some journalists would write!

      I agree wholeheartedly about charities. There are only three ways to trade money: By love (charities), by mutual trade, and by force (taxation). Somehow, I think that the people that want to give out of love are going to care more and be less resentful than the ones who are forced to give, and to give money that could just as well subsidize a company whose practices they don’t agree with, or worse, pay for a war.

      Thanks for the comment!

  3. Everyday Tips says

    September 23, 2010 at 2:22 pm

    We max out our retirement funds each year.

    What a shame it would be if Canada took away the TFSA because of income reduction. Why does money need to be redistributed? Why can’t people take care of their own finances and be responsible for themselves? How puzzling.

    • Kevin says

      September 24, 2010 at 7:02 pm

      Why? Well, we always have a few moralizers who argue that people are bad, so other people should take their money and put it to “better uses”. Try to argue against such people, and they paint YOU as the selfish and immoral person.

      I don’t think that Canada will take away the TFSA because keeping the TFSA is in the interests of the middle-class, which is still the largest block of voters. Things could always change, though.

  4. DIY Investor says

    September 23, 2010 at 9:23 pm

    Do they have other features similar to the U.S. Roth? Do you have to take a required minimum distribution? Is it the preferred vehicle for passing on assets to heirs?

    • Kevin says

      September 24, 2010 at 7:14 pm

      I did a little bit of researching, and I don’t believe that there are any rules about minimum distributions for TFSAs as they are not tax-deferred. At death, it appears that the entire proceeds of the TFSA are then vested to the estate’s beneficiaries, tax free. Qualified survivors can append this amount to their own TFSAs without affecting their own contribution limits.

      I found this website by the Canada Revenue Agency which contains a lot more information about what happens after the death of a TFSA holder: http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/tfsa-celi/dth/menu-eng.html

  5. The Passive Income Earner says

    September 24, 2010 at 5:50 pm

    With the recent arrival of TFSA, I personally prefer maximizing TFSA over RRSP first. It’s much more flexible. Also, depending on your income level and age, maximizing RRSP when you have a higher income may be better. In which case, you can transfer the TFSA over to maximize the tax savings from a higher income. Then you take the refund and put it in your TFSA.

    • Kevin says

      September 24, 2010 at 7:16 pm

      Maximizing RRSP and putting the refund in the TFSA isn’t a bad idea at all. You also bring up a good point that it does depend on the tax rates you are paying now versus where you expect to be in the future, and the flexibility of TFSAs is definitely a plus.

  6. Nirman Broking says

    October 14, 2011 at 3:21 am

    It was a awe-inspiring post and it has a significant meaning and thanks for sharing the information.Would love to read your next post too……

    Thanks

    Regards:

  7. youngandthrifty says

    October 14, 2011 at 6:58 pm

    Thanks!

    I am currently maximizing my RRSP (just because I am a sucker for tax return money).. I am moving my non-registered account into my TFSA account for the time being.

    I hope to be able to max out both continually in the future!

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