**This article is a transcription of the video above, originally published on Youtube. Watch our TFSA Explained video on Youtube!**
What I’m going to be going over today is the Tax Free Savings Account.
What the TFSA is, how to use your TFSA, the TFSA limit in terms of contribution room for 2020 and beyond, and at the end of the article I’m actually going to go over one critical mistake that Canadian investors can make when they’re buying stocks that can end up costing them nearly $700,000 in the Tax Free Savings Account.
So, you’re going to want to stick around until the end of the article. Lets get started.
So to kick things off, what is the TFSA, what does it stand for and what are the TFSA limits?
The TFSA stands for the Tax Free Savings Account.
The account was declared in the 2008 federal budget and the first year it rolled out was in 2009 when investors were given a $5000 TFSA limit.
That $5000 limit carried on for 3 more years until the government bumped the rate to $5500 in 2013. That lasted only 1 more year until 2015 when the contribution limit to the TFSA was nearly doubled to $10,000.
In 2020 the TFSA limit is $6000, so if you were 18 years of age in 2009 you’re going to have around $69,500 worth of TFSA contribution room. Your contribution room starts to add up when you’re 18 years old. So someone who turned 18 in 2009 is going to have the $69,500 in room, while someone who turned 18 in say 2015 is going to have less room because it hasn’t accumulated as much.
The easiest way to check your contribution room is just to create a my CRA account, log in, and it will show you your Tax Free Savings Account contribution room at the bottom of the page.
The TFSA is a relatively young account
With the Tax Free Savings Account being established in 2008, it is a relatively young account. If we look to the RRSP, or the Registered Retirement Savings Plan, this account has been around since 1957.
The United States have actually had an account like the TFSA since 1997, the Roth IRA, and both accounts are very similar.
The easiest way to describe the TFSA is it enables Canadians to build tax free wealth over long periods of time.
The Tax Free Savings Account isn’t JUST a savings account
The number one thing with the Tax Free Savings Account that trips up new investors, and it’s actually right in the name, is that the TFSA is not just a savings account.
Yes, the TFSA can be a great way to build savings, but the fact is, using a completely tax free account to invest in say a GIC or a money market fund is just not the right way to go about things with this account.
You’re not going to pay much tax on these investments anyways because they don’t earn that much, especially in this low interest rate environment due to COVID-19. With these low rates, Canadian dividend stocks are likely to outperform, and you’ll want to stash some of them away in your TFSA.
So yes, you can use this account as a savings account, but the optimal way to use this account is to own Canadian stocks, Canadian ETFs, and even ETFs that track international stocks that trade in Canadian dollars.
US dividend paying stocks in a TFSA and withholding taxes
There’s a group of stocks that I didn’t mention and you might have noticed, and that is US Stocks. Now why do we not suggest investing in US stocks, particularly US dividend paying stocks, inside of a TFSA?
Contrary to popular belief, the TFSA isn’t completely tax free. There is still withholding tax charged on US dividends inside of a Tax Free Savings Account.
The US government has agreed to not tax dividends on accounts here in Canada that are meant to provide tax deferred retirement or pension benefits. The TFSA doesn’t align with this. An account that does? The RRSP.
US Dividends inside of an RRSP are tax free, within the TFSA they aren’t.
We aren’t suggesting US dividend paying stocks don’t belong in a TFSA at all, we’re just saying that it’s better to put them in an account that won’t charge you a 15% withholding tax. Because although it seems minor, it does add up.
Contributions to a tax free savings account are not tax deferred
Contributions to a TFSA are not tax deductible. This is another thing investors get confused with as they are used to getting a tax write off with their RRSPS.
If you contribute $3000 to an RRSP, you can write that contribution off your personal income taxes and potentially (depending on other taxes owed) get a certain portion of that money back.
The Tax Free Savings Account has no taxable benefits in terms of your income. The primary reason for this is because the money can be withdrawn tax free as well.
You will never pay tax on money inside of a Tax Free Savings Account, unless you’ve gotten a little greedy, started day trading and now the CRA is asking you to pay tax on that income. With an RRSP, you’ll be taxed your nominal tax rate when you withdraw the money, whether it be for an emergency for for retirement.
TFSA contribution room is not based on last years income
Another common misconception with the TFSA is the fact you need to have filed taxes or need to have an income for that year to be awarded the full TFSA limit.
This is not the case. The RRSP and the TFSA are two accounts that often get investors confused, and this is another area people fall victim to. With the RRSP, your limits for the following year is based on your last years income.
The TFSA however, is simply given to you at the start of every calendar year.
You get this contribution room no matter what, as long as you’re over the age of 18.
TFSA contribution room with withdrawals
Another thing that really trips up beginning Canadian investors is contribution room when it comes to withdrawals. How will a TFSA withdrawal effect your TFSA limit moving forward?
The best thing about the TFSA, if you managed to make some solid investments within the account, your contribution room won’t go down if you decide to withdraw that money, if you re contribute it the following year.
Lets say for example you’ve contributed the max amount of $69,500 and you’ve managed to turn that into $100,000. You decide to withdraw $40,000 from your TFSA.
You don’t need to be scared that if you withdraw this $40,000 that your contribution room the next year with simply be the amount your given by the CRA.
The formula for your total TFSA limit for the next year is this:
Previous years room + previous years withdrawals + new government allotment
So if you withdraw the $40,000 in 2020, you have the opportunity to re contribute that money in 2021, and your TFSA limit would be as follows:
$0 + $40,000 + $6000 = $46,000
You have that year to get your withdrawal back into the account where it can continue to earn completely tax free.
How many TFSA accounts can you own?
This trips up new investors as well, and the reality is you can have as many TFSA accounts as you wish. You could have 20, 25. Although I really wouldn’t suggest it, you can.
The only thing the CRA cares about is that you don’t exceed your TFSA limit inside of all of these accounts combined.
To keep things easier I would highly suggest sticking to one TFSA. Where I hold mine is Questrade, and if you want you can click this link or use the code Stocktrades50 and get $50 in free commissions when you open an account. All you need to is make 10 trades in your first month.
The most important thing you need to know about the Tax Free Savings Account
So how is the TFSA, one that only has $69,500 in contribution room, potentially costing me nearly $700,000 in tax free money?
As I’ve mentioned before, money earned within a TFSA can be withdrawn and re contributed the next year. So, contribution room can increase.
However, contribution room can also permanently decrease inside of your TFSA.
A lot of investors take a hyper-aggressive approach inside of their TFSAs. They think they want to hit that big stock, that $1 stock that they ride all the way up to $100 and sell it completely tax free, they’re gonna be rich.
Well, more often than not if you take this hyper-aggressive approach you’re just going to end up broke.
If you just turned 18 last year and you’ve got $6000 for your TFSA limit and you decide to buy some over the counter pink sheet stock with your $6000 and the company goes bust or you lose 90% of it, that TFSA room is gone, you don’t get that loss back next year.
If you deposit the $6000, lose that $6000, the next year you’re only going to have TFSA contribution room of $6000, not $12,000.
If you’ve maxed out your TFSA at $69,500, in 30 years if you’ve invested that in stocks, bonds, whatever t may be and you manage an 8% annual return, that money will turn into $699,467.94.
I know this is extreme, but it is a prime example of what’s at stake if you’re reckless with the account.
If you take that $69,500 and buy highly volatile penny stocks with it and lose 90% of it, you’ll have to earn tax-free returns on whatever you have left in the TFSA.
You can’t claim capital losses in the Tax Free Savings Account
If you had a margin or cash account, a non-registered account, and you lose $30,000 on a penny stock, you could counteract any capital gains with that because it’s a capital loss. Inside of the TFSA, there is no taxable benefits to losing money on investments.
This is one really important thing to consider when you’re investing inside of the Tax Free Savings Account. You don’t have to pay capital gains on investments inside of the TFSA, but you also aren’t able to claim a capital loss.
That, combined with the fact that you can permanently lose your TFSA room and lower your TFSA limit, is one of the primary reasons I do not suggest a hyper aggressive approach within your TFSA.
Overall, the Tax Free Savings Account is a very simple account
The TFSA is a great account to earn tax-free investment returns, but is also a very easy account to screw up and permanently damage.
I hope I could explain the Tax Free Savings Account in the shortest amount of time possible! I hope you know what the TFSA is, how to use the Tax Free Savings Account, and if you do drop a comment below and let us know!