Rewind to January 2009, when Barrack Obama made history by being inaugurated as the first African-American president of the United States.
January 2009 also saw the birth of the tax-free savings account (TFSA) in Canada.
Starting with an initial $5,000 limit, tax-free accounts took a while to gain traction. I was working in retail banking during the early years and those who were keen to start their TFSA accounts wondered how much interest they could make on this new "savings" account.
We quickly realized perhaps a better name would have been a tax-free investment account to help promote that investors were not limited to just savings and can hold many different investment options similar to retirement savings plans (RSPs).
According to Revenue Canada's 2021 website figures, more than 15-million Canadians have a TFSA, with an average balance of $22,882.
How they work:
A Canadian resident can open a TFSA at age of majority, which is 19 in BC. Available room starts accumulating at age 18 and, similar to RSPs, unused contribution room is available for future use. The 2022 annual limit is $6,000 and the lifetime limit is $81,500.
Monies in a TFSA can be withdrawn any time and any gains (interest, dividends or capital appreciation) are completely tax free. Investors can also replace any withdrawals the following calendar year without impacting available limits.
You can look up your individual TFSA room online with Revenue Canada or with help from your tax professional. We recommend that individuals only open one TFSA account for ease of tracking deposits and withdrawals. The penalties for over-contributing are strict and levied at one per cent per month by Revenue Canada.
Pro top 1: If maxed out, you can give money to your spouse to invest in their TFSA without any tax implications and utilize their available room.
For estate-planning purposes, tax-free accounts have the ability to name a beneficiary so that proceeds can flow tax-free and avoid probate.
Pro tip 2: If electing your spouse as beneficiary, we recommend having them named as successor annuitant as this allows the deceased's TFSA to be added to survivor's TFSA without affecting the spouse's contribution room.
The power of tax-free savings, example No. 1: Bob starts investing in a TFSA with $6,000 a year and earns an average return of five per cent. After 10 years, his TFSA would grow to $79,241. In 20 years, he would amass $208,316 that he never pays tax on — ever.
Example No. 2: Sara receives an inheritance and places $81,500 into a new TFSA, maxing it out. She never adds another dollar and averages five per cent a year return. After 10 years, her TFSA would be worth $132,755. In 20 years, her TFSA would surpass $216,000 or grow by 165 per cent tax free.
TFSA or RSP?
A common question we are asked is, "Is it better to save in an RSP or TFSA?" The answer will depend on individual circumstance and income. An RSP contribution will get you a tax deduction, investments grow tax deferred and taxed upon withdrawal. This is typically in retirement when individuals should be in a lower tax bracket than their working years.
A TFSA is funded with after-tax dollars and receives no tax deduction, but all future growth is tax-free and withdrawals are not taxed at all.
If you are currently in a lower tax bracket and anticipate remaining in low bracket in retirement, then contributing to your TFSA rather than your RSP could make more sense.
Conversely, if you are in a higher tax bracket and anticipate being in a lower bracket in retirement, then an RSP contribution could be better served.
Another instance a TFSA can be beneficial is if you receive a windfall (inheritance, proceeds from house sale, gift, etc.), as investing in your TFSA keeps all future growth tax-free.
As always, we encourage working with a financial professional to discuss what works best for your specific circumstance.
Until next time, Invest Well, Live Well.
Written by Keith Davis.