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Many Canadians don’t know how TFSAs work, when or why they should contribute to one, and how they compare against RRSPs, regular savings accounts, or other investment products.
If you consider yourself TFSA-confused, take a few minutes to bring yourself up to speed with this quick overview. Under the right circumstances, contributing to a TFSA is a key piece of any sound financial strategy. But to get the most out of them you first need to know how they work and what their limitations are.
What is a TFSA and how does it work?
TFSAs were introduced in 2009 by the Canadian government to encourage Canadians to save more money. Unfortunately, the name “Tax-Free Savings Account” is a little misleading and may explain some of the lingering confusion. TFSAs are neither fully tax-free nor fully savings accounts.
At its most basic level, a TFSA is an account where you can deposit your money and any interest you earn on that money is tax-free. For example, if you invest $5,000 into your TFSA and a few years later with interest it’s grown to $6,000 you’ll pay zero taxes on the extra $1,000 when you withdraw it.
This is the key difference between RRSPs and TFSAs. Unlike RRSP contributions, which lower your taxable income, you do still pay taxes on the money you deposit into your TFSA. You only save taxes on earned interest.
Is a TFSA better than a savings account?
Despite its name, a Tax-Free Savings Account isn’t strictly limited to being a savings account at all. It’s kind of like a personal investing account that can also be used to buy GICs, mutual funds, stocks, and ETFs. All of the earned interest, dividends, and returns from these remain tax-free.
Of course, you can also choose to use your TFSA as a simple savings account as well. The choice is yours and this flexibility is what separates a TFSA from a standard savings account. Before you make that choice, however, take some time to assess your financial situation and understand whether you should be saving or investing.
Using a TFSA to invest in things like mutual funds and ETFs will generally lead to greater compound-interest gains than sticking with simple savings account interest. However, if you’re a new investor you’ll want to educate yourself on how to invest safely and strategically before using TFSAs to invest in more advanced financial products.
How much money can I put in my TFSA?
One thing TFSAs have in common with RRSPs is they also have yearly contribution limits. Unlike RRSPs though, TFSA limits aren’t tied to your income. They’re set each year by the government and unused amounts roll over from year to year to a lifetime limit that’s also updated yearly.
What is the TFSA limit in 2023?
For 2023, the contribution limit is $6,500 and the lifetime limit for rolled over amounts (also known as your TFSA contribution room) is $88,000. The amount applies if you were 18 years old in 2009. That is when your contribution room starts. The Canada Revenue Agency (CRA) tracks your contribution room for you, so if you’re not sure what yours is at the moment you can find out online or over the phone.
Pay close attention to your contributions. There’s a steep penalty for contributing over your limit. Even if you over-contributed accidentally, you’ll be dinged a 1% penalty on your excess contributions every month until you withdraw it.
What happens if I take money out of my TFSA?
One of the main advantages of a TFSA is you can withdraw your money at any time and without penalty. Unlike RRSP savings, you’ve already paid taxes on your TFSA amounts so the money is yours to withdraw (although depending on your financial institution you may incur a small transactional fee).
However, if you do withdraw money from your TFSA you can’t put it back right away. You’ll need to wait until the following year to gain that contribution room back.
How do I maximize my TFSA?
TFSAs are a great tool anyone can use to build their savings but if you’re not using them properly you might be leaving money on the table. Follow these simple rules to maximize your TFSA.
1. Start with the right savings goals
To get the most out of TFSAs, you need to understand your financial goals. If your goal is to save for your retirement, RRSPs may be a better option to start with. However, if you’re already annually maxing out your RRSP contributions then contributing to a TFSA is a logical next step.
If your goal is to save for a large financial purchase, TFSAs are ideal because you can withdraw them anytime without penalty (unlike RRSPs).
2. Choose the right account
Depending on your savings goals, spend some time exploring the different options available to you for opening a TFSA. You can open one (or several) through your bank and use it as a simple savings account, or you can open one for through a service like Wealthsimple or Questrade for investing in financial products like stocks, mutual funds, and ETFs.
3. Choose the right products
There’s no right answer for how you should use your TFSA. If you want to maximize your gains through interest and dividends, you’ll need to invest your TFSA dollars in high-growth vehicles like mutual funds, stocks, bonds, and ETFs. Before you dive right in, make sure you educate yourself on how to start investing, and whether you should be saving or investing.
4. Maximize your contribution room
Getting the most out of your TFSA typically means maxing out your contribution limit year over year. This isn’t always possible but if you have the means doing this will maximize the amount of tax-free gains you can earn each year. Over the course of several years or even decades, this will add up to meaningful amounts that can be reinvested again and again.
5. Automate monthly contributions
Few people have several thousand dollars lying around waiting to be plunked into a TFSA once or twice a year. If you rely on dumping large chunks of extra cash into your account in order to grow your TFSA, chances are you’ll always find other ways to spend the extra money.
Instead, set up reasonable automatic monthly or bi-weekly contributions to your TFSA. You can schedule these automatic contributions to coincide with your paychecks and only contribute a set amount you’re comfortable putting aside for your savings goals.
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