Tax Free Savings Account (TFSA)

The Tax Free Savings Account, commonly called the TFSA, is an easy and highly adaptable investment account where Canadians can save and invest money for the long-term or for the short-term. It is a great account in which to save money, invest for high gains, and never pay income taxes or investment taxes on those gains again.

While the RRSP can be a better way for the average Canadian to save for retirement, ultimately saving them more money in taxes if executed properly, the TFSA wins in terms of flexibility, ease of use, and versatility for Canadians in all financial situations.

When used to its full potential, the TFSA is a very powerful investment account that can save you a significant amount of money in taxes on your investments.

What is a TFSA Exactly?

A TFSA is an investment account that shelters your investment returns within your account from taxation and ensures you will never need to report or pay taxes on any withdrawals you make from your TFSA account.

You contribute to your TFSA with your net income—your after-tax earnings. Adjusted for income taxes, you can contribute less money to you TFSA than to your RRSP. You can use your TFSA to invest in a wide variety of investment instruments and pay zero tax on any of the gains from those investments.

Perhaps the greatest strength and weakness of the TFSA is that it is extremely easy to take money out of the account. TFSA accounts are very flexible and have few restrictions.

It is important to understand that a TFSA is not just a different kind of savings account you can open at your local bank and collect a little bit of interest. It is also not best used as an account to save some money for a near term purchase. The best way to use a TFSA is to save and invest for retirement.

Your TFSA can hold a range of qualified investments: publicly traded stocks, bonds, listed options, GICs, ETFs, REITs, mutual funds, mortgages packaged within a mortgage investment corporation, a mortgage on your own house using a mortgage trustee, precious metals, certain foreign currency exchange investments, and small business shares in limited cases.

A TFSA is a flexible investment account with special tax privileges. You can manage your own TFSA via a self-directed brokerage account like Questrade, you can hire an advisor to manage your TFSA investments on your behalf, or you can engage a trustee to secure certain TFSA investments.

A TFSA account is the perfect place to make compounded returns over long periods of time. You should aim to make good investment returns at your appropriate risk level.

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Basic Tax Structure

The tax structure of the TFSA account is very simple and straightforward. With this explanation I hope you will understand how TFSAs work and how they can save you a substantial amount of money over the course of your life.

  1. You contribute to an TFSA account with after-tax income.
    • If you are an employed person, you will generally have income taxes withheld from your paycheque. Your after-tax, or net income, is lower than your pre-tax, or gross income. You are contributing to your TFSA with money you have already paid taxes on.
    • Unlike the RRSP, you cannot deduct your TFSA contributions from your taxable income when filing your taxes.
    • For example, if you earn $50,000 and pay income tax of $10,000 on that income, you contribute to your TFSA account from the $40,000 after-tax income level.
  2. You do not pay taxes on investment income earned within your TFSA account.
    • When you invest, you will likely be generating investment income such as dividends or interest payments. You may also realize capital gains when selling your investments in your TFSA at a profit. Any income or profit earned within your TFSA account is not reported and is not taxed.
    • For example, if you earn $50,000 a year at work, your TFSA investments earned interest income of $5,000, and you sold an investment in your TFSA for a profit of $25,000, you only need to report and pay taxes on the $50,000 you earned at work. You do not report or pay tax on any investment income earned within your TFSA account.
  3. Money you withdraw from your TFSA account is not reported and not taxed.
    • You can pull money out of your TFSA account at any time and pay no taxes on that withdrawal. You also do not report the withdrawal on your tax return. It does not count as income.
    • For example, if you earned $50,000 a year and work and you withdrew $10,000 from your TFSA, you will only need to claim the $50,000 you earned at work. The money you withdrew from your TFSA is yours to keep free of taxation.

You can think of your TFSA as an investment vehicle where you pay no taxes on any investment income you receive and no taxes on any withdrawals you make from your TFSA. However, you do not get to claim a tax deduction when you contribute to a TFSA account.

Understanding the tax structure is very important and can help you decide when you should contribute to your TFSA instead of your RRSP account.

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When Should I Contribute to a TFSA?

Every Canadian should open and contribute to their TFSA account regardless of their income level and use for the account. While best used for long-term saving and investing such as retirement, the TFSA can also be used effectively for shorter duration needs.

Since investment gains and withdrawals from your TFSA are not reported or taxed, contributing to your TFSA does not require a lot of planning. However, if you have a limited amount of money to save and invest for the long term, you may question if you are better off contributing to a TFSA, or if you should contribute that money to your RRSP account instead.

Between the two major registered, tax advantaged accounts, the TFSA is certainly the more flexible one. If you are not a planner, if your financial situation is likely to change significantly, or if you believe it is unlikely that you can plan withdrawals from a RRSP account at a low tax rate, you should probably contribute to a TFSA instead of a RRSP.

The TFSA is also the better option if you are a low income earner or if you are likely to earn a significant pension or other income in retirement. As a low income earner, you do not benefit from contributing to a RRSP since you are not saving a lot of tax on your contributions. In addition, you must report and pay tax on RRSP withdrawals. Since TFSA withdrawals are not reported and not taxed, a low income earner will still be able to benefit from low income elder benefits and subsidies in retirement. This could include everything from eligibility for the Guaranteed Income Supplement (GIS) to low income housing subsidies to dental and pharmacy subsidies.

The TFSA is great for pensioned employees because employees with good pensions coming to them when they retire are likely to be forced into higher tax brackets. Withdrawals from a TFSA are a great way to boost retirement income without paying more tax. TFSAs can save retirees a substantial amount of money in taxes and may prevent Old Age Security clawbacks.

A TFSA account is also a great account to save for large purchases that you might make in the distant future. For example, many retirees may purchase a second home in a warmer climate, a large RV, or splurge on a few pricey and long vacations. Using your TFSA to pay for these big one-time expenses is a fantastic way to save money on taxes you would otherwise pay making a large withdrawal from your RRSP account.

You should contribute to your TFSA if you are making very high returns on your investments. Gains made in TFSAs are never taxed: not when you realize them and not when you withdraw them.

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TFSA Contribution Limits

If you decide that contributing to a TFSA account is right for you, make sure your contributions stay within the contribution limits.

Every Canadian who is 18 years of age or older is eligible to open a TFSA account and can contribute money to that account each year. The annual contribution limit is set at $6,000 (in 2019) and rises with inflation in increments of $500. Every few years, the contribution limit is increased.

Any contribution room you have not used is rolled forward and added to the new contribution limit for the current year. If you have never contributed to a TFSA account before, you may be able to contribute as much as $63,500 provided you were 18 years old in 2009 when TFSAs came into law.

Also, if you withdrew money from your TFSA in previous years, your TFSA contribution room will be adjusted for that withdrawal amount. You may re-contribute the entire amount you withdrew, plus any cumulative new annual contribution amounts. Be careful not to withdraw money from and contribute money back to your TFSA within the same calendar year. This is true even if you have several TFSA accounts with different institutions. Canada Revenue Agency will classify this as an excess contribution.

You can find out your TFSA contribution limit for the current year by registering and logging into My Account online with Canada Revenue Agency or by calling Canada Revenue Agency. However, this number is reported to Canada Revenue Agency by your brokerage or bank and may not be accurate. You are 100% responsible for tracking your past and current contributions, making sure you stay within the prescribed amount.

Be careful not to contribute to your TFSA past your contribution room limit. Any excess contributions are taxed at a penalty rate of 1% per month. You may also be taxed 100% on any gains you make on the excess contributed amount.

If you accidentally make an excess contribution—which is surprisingly common for people with more than one TFSA account and people who don't do a proper TFSA transfer—immediately withdraw the excess amount. Call Canada Revenue Agency right away and they will have you fill out some forms.

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Transferring Your TFSA

Thanks to aggressive marketing campaigns by banks promoting TFSA accounts, and the general misunderstanding many Canadians have about the possibilities and power of the TFSA, it is not uncommon for people to have several TFSA accounts at different financial institutions with relatively small balances. Most of these will be held as a regular savings account earning a small rate of interest, not invested for real growth.

If you decide to use a TFSA account to its full potentially, you would benefit from consolidating your various TFSA accounts into one self-directed investment TFSA or a TFSA managed and invested by a professional on your behalf.

You may also decide to move your TFSA to a new brokerage for cost or service reasons.

Transferring money from one TFSA account to another TFSA account is a bit of a tricky process and must be done carefully to avoid accidentally making an excess contribution. There are two ways to do this transfer correctly:

  1. Open your new investment TFSA account. Make sure your existing TFSA account(s) that you are transferring is in cash or the investments the account holds are able to be transferred "in-kind". Also, check with your existing TFSA account provider to see if they charge fees for transferring out your account. Use your new TFSA brokerage to request the funds via a full transfer from your existing TFSA account(s). This initiates a clean transfer process from one account to another.
  2. Open your new investment TFSA account. Wait until the 20th of December, then sell your existing TFSA account(s) assets and withdraw the money to your chequing account. Wait until January, then move the money from your chequing account to your new TFSA account. This process may help avoid fees, but make sure you do not withdraw from one TFSA account and contribute to another TFSA account in the same calendar year.

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When Should I Withdraw from a TFSA?

There are effectively no limits on withdrawing money from your TFSA account. You can withdraw money at any time, for any reason, and you will not need to report or pay taxes on the withdrawal amount.

However, to use your TFSA account to its full potential, you should try minimize withdrawing from the account if at all possible until retirement.

Retirement

The TFSA is often branded as a savings account, but it is best used as an investment account where Canadians can save for retirement.

If you have contributed the maximum amount to a TFSA during your working years, and you have invested it properly without making any withdrawals, it is likely that your TFSA will have grown to a low seven-figure account.

This can provide you with an enormous amount of tax free income in retirement. A couple may be able to easily fund their entire retirement from their TFSA accounts. Since this income is not reported, you may also be eligible for elder benefits normally reserved for low income retirees. However, I wouldn't count on this remaining as more and more TFSA accounts grow to substantial sizes.

Large One-time Purchases

A TFSA account can also be useful in funding large purchases that you wish to make in cash. Particularly if you are older and your TFSA has less time to compound in size.

However, if you are younger, explore other funding options first. It may be cheaper in the long run to obtain a low interest loan or use money in a non-registered savings account, even if you need to pay some capital gains taxes to access that money.

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When to Avoid Using a TFSA

TFSA accounts are so flexible and versatile with great tax benefits there is hardly a time where one should not invest in a TFSA account. They are good investment accounts for any situation.

However, there may be occasions where it is better to invest in a RRSP account instead of a TFSA. This consideration is only true for people with limited savings capacity who cannot contribute to both accounts.

High Income Earners

The TFSA is often not the best registered account option for people who earn a high income and who can develop a great plan to withdraw money from a RRSP account at low tax rates in the future.

Unlike a TFSA, a RRSP can allow investors to capture a significant tax spread from the tax rates when contributing to the account to tax rates when withdrawing money from the account. This is in addition to the tax sheltering of investment income that both registered account provide investors. This means a RRSP investor can contribute more money to their account when they gross-up their contributions, compounding that money faster and gaining more overall wealth.

With some proper planning and foresight, a RRSP contributor may be able to save up to 54% income tax on the money they contribute to their RRSP account. They may be able to withdraw money from their RRSP later at tax rates well below 25%. In certain cases they may be able to almost completely avoid paying tax on RRSP withdrawals.

Certain Traders or Investment Insiders

Canada Revenue Agency has recently begun taking a serious look at investors who have accumulated massive amounts of money in their TFSA accounts. They are particularly interested in people who show signs of superior investment knowledge and people who use an unfair advantage.

How Canada Revenue Agency defines this is still somewhat unclear. Court rulings on the subject didn't help very much and it looks like some of these cases are almost a witch hunt against successful, savvy investors who are using their TFSA to its full potential.

However, you should not use your TFSA to do the following:

  • Day trade or actively trade in a way where your investing may be considered a business venture rather than an investment
  • Use highly complex options strategies, particularly those which involve selling "naked" options for income
  • Purchase or engage in complex transactions that are not normally commercially available to the average investor
  • Invest in anything this is not a qualified investment

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Holding Your Own Mortgage Within Your TFSA

One of the more interesting use cases for your TFSA is to hold your own mortgage. You can legally use your TFSA to fund all of, or part of, your house purchase or refinancing and become your own bank. However, there are a large number of rules surrounding the structure and safeguards in place to ensure it is all done correctly.

Holding your own mortgage is called a self-directed TFSA non-arms length mortgage. This is a fancy term that means your TFSA has a close relationship with you, as the account holder, so you need to abide by special rules to ensure you are not abusing your TFSA account.

This may sound complex, but it isn't. All you have to do is hire an approved trustee service to manage the paperwork for you and administer the mortgage terms. Some common trustees who offer this service include Canadian Western Trust, TD Bank (Canada Trust), and B2B Trustco. Contact them for all the information you need, and don't be surprised if you need to push a little beyond the sales pitches; after all, they make their real money selling you mortgages.

Your trustee makes sure you follow the standard rules that apply for all commercially available mortgages. You will probably need to get a professional house appraisal, you must maintain a loan-to-value ratio of 90% or less, you must obtain mortgage insurance from CMHC or Genworth Financial to protect your TFSA against default losses, you must choose mortgage terms that are in line with publicly available mortgages, and you have to demonstrate your credit worthiness through credit checks, income verification, and so on.

The fees to establish a self-directed TFSA non-arms length mortgage are not cheap, but also not that extravagant considering the money you will save on interest expenses. The trustee will charge around $500 to do the initial setup and paperwork. The property appraisal will cost about the same amount. Your mortgage insurance costs depend on your loan-to-value ratio, but can cost several thousand dollars. Finally, the ongoing fees charged by your trustee will run around $200 per year. There are also fees for rolling over your mortgage to a new term, requesting certain paperwork, and so on.

You are able to deduct the setup fees, interest costs, and administrative fees from your tax return in certain situations. For example, if you have enough equity in your house you may take a TFSA non-arms length mortgage on your home. Your TFSA, through the trustee, will essentially write you a cheque for the borrowed amount. If you invest this borrowed money in a non-registered account and purchase stocks which pay a dividend, you have a tax deductible investment loan. This can provide significant tax benefits to you!

Once it is all established, you will make bi-weekly or monthly payments to your TFSA as per your chosen mortgage terms. Your TFSA collects the interest and over time your principal balance is reduced, just like a standard mortgage. Don't forget to regularly invest the money sitting in your TFSA as you make your mortgage payments!

Over the course of a standard 25 year mortgage amortization, you can save yourself hundreds of thousands of dollars in interest costs by funding your own mortgage through your TFSA. This is money otherwise lost to the banks. You can also grow your TFSA substantially in a legal and tax free manner.

Some Interesting Notes

Holding your own mortgage within your TFSA is not a creative way to begin financial shenanigans. Your trustee is legally obliged to ensure you make your payments on time as required. If you don't make your payments, your trustee is required to initiate a foreclosure process on behalf of your TFSA. Your TFSA will take possession of your house and your trustee will sell it on their terms within one year. As you might expect, the fees your trustee charges for this process are very substantial!

Try choose common mortgage term lengths, such as five or ten years. This will save you money in fees as the trustee charges you for rolling over your mortgage and setting a new term.

Since you are not taxed on the gains made within or withdrawals from your TFSA, there is a special use case to have a high interest mortgage within your TFSA. You can legally create your own high interest mortgage by making your TFSA hold a second place mortgage on your home. In this structure you could charge yourself interest rates at Bank Prime plus 10% or higher, helping your TFSA grow faster and at a guaranteed rate.

You can use this type of TFSA mortgage to purchase certain multi-family income properties. You must reside in one of the units, the property cannot have more than four units in total, and you must meet the other standard terms for this kind of loan. This could be a great way to fund a duplex or tri-plex property where you are your own onsite property manager.

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Non-residents and TFSAs

If you have a TFSA account and you become a non-resident of Canada for tax purposes, you can legally retain your TFSA account and continue investing within that account. However, the TFSA is not recognized as a registered account by any country that has a tax treaty with Canada. This means that while you may avoid paying any taxes on investment gains in your TFSA to the Canadian government, you will need to report those gains to the country where you are currently residing.

You may not make new contributions to your TFSA account if you are a non-resident. You can only manage and grow the money already in your account on the date you left Canada.

If you plan on returning to Canada in a few years, it probably makes a lot of sense to keep your TFSA account active and continue investing and growing your account. This is true even if you must declare some gains and pay some taxes on those gains in your current country of residence.

However, if you have no plans to return to Canada, it is often easier to withdraw money from your TFSA tax free when leaving Canada and begin investing in a non-registered investment account, or a special purpose investment account offered by your new country of residence. If you end up returning to Canada in the future, you can open a new TFSA, contribute the amount you withdrew from your TFSA when you left, and any new contribution room you will gain within the contribution limits.

If you choose to keep your TFSA account active and continue investing, remember that not all brokerages will allow customers to maintain their TFSA accounts after they become non-residents. If this is the case for you, find a brokerage that accepts non-resident accounts. As of 2019, Questrade is one of the brokerages that does.

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Dying with a TFSA

When an individual with TFSA account dies, the value of their TFSA will normally become part of the estate. The account is withdrawn tax-free and is distributed to the estate beneficiaries. During the probate process, the TFSA account itself will remain tax free for the estate until it is withdrawn, but no longer than the end of the first calendar year following the TFSA holder's death (exempt period). However, the beneficiaries (not the estate of the deceased) will owe income taxes on any gains made following the TFSA holder's death.

The deceased's TFSA account can be transferred completely tax free with no impact on the recipient's TFSA contribution limit if the recipient is the deceased spouse or common-law partner and is declared as the account "successor holder". This transfer can be done quickly and outside of the probate process.

If the spouse or common-law partner is not named as the successor holder, but is a beneficiary of the TFSA, they can still receive the deceased person's TFSA assets into their own TFSA without any impact on contribution room. However, this transfer must be completed with the exempt period and must be declared as an exempt contribution with Canada Revenue Agency.

Be sure to speak with an accountant or estate lawyer to ensure a smooth tax-efficient estate process.

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