Tax-Free Saving Accounts

Awhile back I talked about which vehicles I would use for certain investments. One of the key accounts to my plan is the Tax Free Saving Account (TFSA). We all hate paying taxes so today I want to go into a little more detail about TFSAs and why you should take advantage of them.

First thing is first - here are some of the rules you should be aware of when using TFSAs:

- At the beginning of each calender year, every Canadian over 18 years of age is allowed to contribute up to $5000 into their TFSAs*. 
- Funds can be withdrawn at anytime and the amount withdrawn is added to next year's contribution room.

-Withdrawals from TFSAs and profits made inside TFSAs will not affect benefits such as the Old Age Security (OAS) or Guaranteed Income Supplement (GIS) so no clawbacks will occur.

- All gains made in the account is tax-free. This includes everything from interest, and dividends to capital gains.

Now that we know how TFSAs generally work, how do we use them to our advantage? There are a couple ways to use TFSAs. People can use them to hold emergency funds, to hold investments and of course we can also use them as... saving accounts (obviously).

Using TFSAs to hold emergency funds is great because they are easy to access but the return is also higher than just putting the money in a regular savings account. The easy access can also be disadvantageous because it can be tempting to spend the money in the account. An important thing to remember is that when funds are withdrawn, they can't be put back into the account in the same year. Unless you had room of course. Many Canadians do not understand the rule so make sure you know what's going on because many have been penalized for over-contributing.

For example, I could have contributed $2000 (leaving $3000 contribution room) and then I totaled my car. I withdraw $1000 to repair the damages. I then save up $1000 later on in the year which can be put back into the TFSA (leaving $2000 contribution room left for the year). The following year I can contribute $6000 ($1000 from what was withdrawn plus the additional $5000). If I contributed $5000 instead of $2000 then I would not have been able to replace the $1000 that was withdrawn to repair the car.

The name Tax-Free Saving Accounts can  be misleading because they can also be used for investing purposes. Many brokers offer TFSA investing accounts so everything earned would be tax-free. However, it should be noted that capital losses can not be written off in TFSAs. Using them to shelter income from interest is great because interest is the least favourably taxed. Assets such as bond ETFs and GICs can be held in TFSAs to take the most advantage of the tax-shelter. Dividends from many Canadian companies are eligible for the Dividend Tax Credit and only 50% of capital gains is taxed so they can be held in non registered accounts. Of course if there was enough room in your TFSA then you should put everything in there!

Using TFSAs as saving accounts is another option. I feel that this option is one of those "better than nothing" choices. They are significantly better than using non registered accounts though so if investing doesn't interest you, you should still seize the opportunity to save money on taxes. Many of the people I know believe that it's too much work or that they don't have enough money to make it worth it. Setting up a TFSA takes about as much time as setting up a non registered account. Also, the fact that they don't have a lot of money should motivate them to try and preserve as much of their wealth as possible making it even more important to use tax-shelters when possible. You have to start somewhere right? Might as well start early and with all the advantages you can get.

Do you use TFSAs? If so, what do you use them for?

-the Paperboy

*This is a general statement due to different laws in different provinces and territories having different age requirements. Certain provinces and territories only allow people to enter into a contract at the age of 19. However, contribution room starts accumulating at age 18 so when the person turns 19 he or she will be able to contribute $10000 ($5000 from the previous year and $5000 for the current year). Also, on the year that someone turns 18, they are allowed to contribute the full $5000 - even if his or her birthday is in December.