Rewind to 2009, when Barrack Obama made history by being inaugurated as the first African-American president of the United States. It was also the birth of the tax-free savings account (TFSA) in Canada.
In the early years, investors were keen to see 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 the fact investors were not limited to just savings and can hold many different investment options, similar to retirement savings plans (RSPs).
How they work
A Canadian resident can open a TFSA at age of majority, which is 19 in B.C. Available room starts accumulating at age 18 and, similar to RSPs, unused contribution room is available for future use. The 2023 annual limit is now $6,500 and the lifetime limit is $88,000.
Money in a TFSA can be withdrawn any time and any gains (interest, dividends or capital appreciation) are completely tax-free.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 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 Tip No. 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 No. 2: If electing your spouse as a 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 1: Bob starts investing in a TFSA with $6,500 a year and earns an average return of five per cent. After 10 years, his TFSA would grow to $85,844. In 20 years, he would amass $225,675 that he never pays tax on — ever.
Example 2: Sara receives an inheritance and places $88,000 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 $143,343. In 20 years, her TFSA would surpass $233,490, or grow by 165 pre 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 are 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.
The views expressed are those of Eric Davis, Senior Portfolio Manager and Senior Investment Advisor, and Keith Davis, Associate Investment Advisor, TD Wealth Private Investment Advice, as of January 25, 2023 and are subject to change based on market and other conditions. Davis Wealth Management Team is part of TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc. which is a subsidiary of The Toronto-Dominion Bank. For more information, call 250-314-5124 or email keith.davis@td.com.
