Using an investment tool like a TFSA can help you invest for the future and save tax. In this article we look at the advantages and disadvantages of a TFSA to help you decide if it the right tax savings tool for you.
What is a TFSA?
A TFSA or Tax-Free Savings Account is a Canadian tax benefit account that allows you to earn investment income tax-free. All investment income earned in your TFSA account including capital gains and dividends are not subject to tax. You do not receive a deduction when contributing to your TFSA and you do not pay tax on your withdrawals.
Who Can Contribute to a TFSA
All Canadian residents 18 years and older can contribute to a TFSA account up to their maximum contribution limit.
Advantages of a TFSA
- All investment income is not subject to tax
- Withdrawals are not taxed
- You can contribute or withdraw funds at any time
- Withdrawn gains increase contribution limit
- You do not have to report TFSA earnings on your personal tax return
Disadvantages of a TFSA
- No income deduction or deferral of tax on high rate income
- Capital losses cannot be claimed
- If you lose money, you do not get the contribution room back
- Over-contribution penalties are punitive
- Cannot be used as an active investment account (day trading)
How do I Receive Contribution Room?
Unlike an RRSP, the TFSA contribution limit is a fixed annual amount. All Canadians residents 18 years and older receive the same fixed contribution limit. This limit is set each year by the Canadian government (the 2017 limit is $5,500). Your contribution limit carries forward each year and is only reduced by your contributions.
Contribution limits are not prorated, and people who become residents or turn 18 in a year will receive the full limit for that year. Conversely, people who become a non-resident in a year do not get the contribution limit for the year.
Nathan turned 18 on December 3, 2015. On February 5, 2017, Nathan opened a TFSA with his bank. His contribution limit is $21,000 ($10,000 for 2015, $5,500 for 2016, and $5,500 for 2017). On the date he opened his account, he invested $6,000 in his TFSA. His remaining contribution limit for 2017 is $15,000.
Other Factors that Change Contribution Limits
While deposits into your TFSA decrease your limit, withdrawals increase your limit. If your contribution is $20,000 and you withdraw $5,000, your new contribution limit will be $25,000.
A common misconception with TFSA’s is that the changes within the account impact contribution limits. Your limit can only change when you receive your yearly limit increase, deposit funds, or withdraw money. The investment income or losses within your TFSA do not change your contribution limit. This can be advantageous if your investments do well, but detrimental if your investments are doing poorly.
John has deposited $40,000 into his TFSA over the years. He invested the money in stocks, and the total current value of all the assets in his TFSA is $30,000. If he sells his assets and withdraws the money, his contribution limit will go up by $30,000, and not by the $40,000 he originally contributed. Conversely, if the asset value increased to $50,000, and he withdrew the full amount, his contribution limit would increase by $50,000.
Where Can I Find my Contribution Limit?
If you are unsure what your limit is, you can check with the CRA. The easiest way to check is by using your CRA My Account. In your My Account, you can see a detailed breakdown of your contribution limit. It should be noted that the My Account statement will not show transactions made in the current year, and it is important to factor in deposits and withdrawals you have made in the current year. You can use this worksheet. http://www.cra-arc.gc.ca/E/pbg/tf/rc343/rc343-12-16e.pdf
Don’t have a My Account? Learn more about the benefits and how to sign up.
Should I Use a TFSA?
Your TFSA is just one of the investment tools available to you. Deciding on whether it is right for you is dependent on your own situation. Read about the 5 advantages of an RRSP to help further assess your situation.
Using your TFSA can be very advantageous as the investment income you earn is not subject to tax and withdrawals are not taxed. Tax reporting of regular investing accounts can also be complicated and time-consuming, therefore investing in your TFSA instead of a non-registered account can be advantageous as it can save you time when filing your personal taxes.
It is important to note that you cannot deduct losses, so risky investments with a high potential for loss may not be the best option in your TFSA as you cannot claim a loss.
Each person is unique, and the best option for you should be discussed with your investment advisor.