Finances Archives - Page 11 of 11 - Wealth Whispers Blog

Want to take advantage of Canadian Registered accounts but also crave flexibility? Then the Tax Free Savings Account (TFSA) is to solution for you. TFSAs are the most flexible of the Canadian registered accounts, allowing you to withdraw funds at any time, and allowing you to use them for any purpose. So you can use your TFSA for saving for school, a car, a down payment, vacation, etc. In this article I am going to cover the following: TFSA Basics What are the benefits of using a TFSA? What are the limitations of using TFSAs? Tips to maximize effectiveness, and grow your wealth tax free What are some potential traps associated with TFSAs? TFSA Basics Similar to other registered accounts, TFSAs can be seen as a bucket, in which you can hold multiple types of investments. TFSAs allow you to grow your money without paying any tax on the growth/income. But in order to be growing your money, you need your money to be invested. Having money in a TFSA without investing has (basically) no benefits. Of course, because TFSAs have this tax advantage, they also have limitations, with the most notable being the total contribution limit. As mentioned above, TFSAs allow you to not pay tax on any income or growth on the money in your TFSA(s). So what that means is that any capital gains, interest income, or dividends received on the assets stored in a TFSA are not taxed. So if you had $10,000 in a TFSA, and that doubled to $20,000, that $10,000 gain is all yours, no tax! Compare this to a non-registered account where any growth would be taxable, resulting in reduced returns on your investments. Assets you can hold in a TFSA TFSAs allow you to hold a number of asset types, including: Cash Mutual funds Securities listed on a designated stock exchange (i.e. stocks) Guaranteed investment certificates (GICs) Bonds Certain shares of small business corporations. You can also open as many TFSAs as you want, at multiple institutions (e.g. banks), so long as you don’t exceed your total contribution limit (i.e. the sum of the contributions across all your TFSAs doesn’t exceed your limit). So you could have a self-directed TFSA where you invest in individual stocks at one bank, a TFSA that holds mutual funds at another, and a third TFSA for GICs. TFSAs can also hold foreign currency (so long as your contribution equivalent in CAD doesn’t exceed your limit). So this means you could contribute and hold U.S. Dollars in a TFSA, and use that to purchase U.S. stocks. Thought there are some implications to this when it comes to dividends (more on that below on the traps section). What are the Benefits of Using a TFSA? There are two main benefits to Tax free savings accounts: Tax free growth, and flexible withdraws As the name suggests, tax free savings account allow you to grow your money tax-free. Meaning no tax on dividends, capital gains, etc. Let’s imagine you own 1000 shares of a stock, and that stock has a 5% dividend yield. In a non-registered investment account, that dividend would be taxable, however with the TFSA, you don’t pay any tax on that income. As well, if you hold those stock for a few years and they increase in price by 25% and you decide to sell, the entirety of that gain is yours to keep, with no tax paid. As you can imagine, this can accelerate the growth of your money as you don’t have taxes cutting into your gains. The other main advantage of TFSAs is that you can withdraw the money without penalty and without taxes. Meaning you can withdraw at any time to purchase a car, for a vacation, or just for everyday spending. Keep in mind how this affects your contribution limit, more info below in the traps section. What are the limitations of using TFSAs? Of course, because tax free savings accounts provide a tax advantage, there are limitations to how they can be used. See Tax Free Savings: TFSA Traps to Watch Out For for more info before you invest. The most notable limitation of TFSAs is the contribution limit. TFSA Contribution Limits Staring in 2009, every Canadian Resident over the age of 18 is allocated an annual contribution limit. Each year, the Canadian government specifies the annual contribution limit, and the total contribution room is cumulative (so if you didn’t use all your room in the previous year, it’s added to the following years growth). So for example, in 2022 the contribution limit was $6,000, the in 2023 it was increased to $6,500. So if in 2022 I contributed $3,000, in 2023 I would have $9,500 of contribution room (remaining $3,000 from 2022, plus $6,500 in 2023). The contribution limits grow with inflation, and the annual limits can be seen on the Canadian Government's Website. If you exceed your contribution limits, the government will apply a 1% tax EVERY MONTH to any funds in the account above the contribution limit. So it’s really important to be aware of your contribution limits. You can see your limits on your CRA account. It’s important to note the CRA updates this value once a year. You must track your intra-year contributions to make sure you don’t over contribute. Withdrawals from Tax Free Savings Accounts The other limitation is that though you can withdraw the funds at any time, the contribution room doesn’t reset until the following calendar year. Imagine you had $10,000 of contribution room in 2023, and you deposited the full $10,000 to your TFSAs in 2023. Later in that year, you withdraw $5,000 from your TFSA. Your withdrawal is not subtracted from your contribution limit in 2023. If you have already used the full contribution for 2023, and you cannot contribute any more in 2023. The following year, that $5,000 of contribution room will be re-added on top of the annual allocation. So in 2024 you would have $6,500 of annual contribution, plus the $5,000 of contribution room you created by withdrawing in 2023. Contributing more to your TFSAs in 2023 (even if you had withdrawn), would be considered an over-contribution, and would be taxed. Tips to maximize effectiveness, and grow your wealth tax free Tip #1 - Put the money in your TFSA to work, tax free The main advantage of TFSAs is that you don’t pay tax on any growth. Therefore, you should be investing the money in your TFSAs to create growth. Using a TFSA as a savings account is a wasted opportunity and doesn’t provide you any advantage. Hold cash in non-registered account. Invest the funds in a TFSA in one of the asset types outlined above (stocks, mutual funds, etc.). Tip #2 - Use the TFSA for long term growth, tax free TFSAs allow you to withdraw at any time, but you can get the most advantage out of your TFSAs by leaving the funds in for long term growth. TFSAs have a contribution limit, meaning you can only add new money in to a limit, but there is no limit to the TFSA account balance. For example, you contribute your max ($6,500) in 2023, but if that $6,500 grows by 8% to $7,020, you’ve essentially increased your contribution limit by $520. As this money continues to grow, you are saving the tax on the growth of $7,020, meaning less tax. If you were to leave that $6,500 for ten years at 8% growth, it would compound to $14,033, meaning you’ve gained $7,533, tax free! So leaving your money in the TFSA to compound means you get the snowball effect of compounding. Taking money out will interrupt this compounding effect. Potential traps associated with TFSAs? There are two potential traps associated with TFSAs: Trap #1 - Holding Tax on Foreign Dividends When you invest in foreign stocks (e.g. US stocks), and those stocks issue a dividend, the US government will hold a 15% withholding tax. If you holding the stocks in a taxable account, you would be able to get that 15% back since you’d be paying Canadian taxes on the dividend. But in a TFSA, you aren’t paying taxes on that dividend income, so you can’t get the 15% back. It's important to be aware of this tax and build your portfolio with this in mind. If you're investing in individual U.S. stocks, this is hard to avoid. If you're investing in index funds, where possible try to purchase those listed on the Toronto Stock Exchange (TSX) rather than the New York Stock Exchange (NYSE). For example for a S&P500 index fund, a Canadian option is ZSP.TO. Trap #2 - Transferring TFSAs If you had two separate TFSAs (either at the same institution, or a different ones), and you withdrew the funds from one TFSA, and then deposited it in the other TFSA, this may be considered an withdrawal, and result in an overcontribution to you TFSA. When transferring funds between TFSAs, it’s really important to make sure you transfer them directly. Transferring directly typically involves creating a transfer request at the destination bank (where the funds will ultimately end up). This may take a few weeks, but initiating is typically easy. Contact your bank to see their specific process. So there you have it. TFSAs are a great tool for building wealth, and minimizing tax. If you want to learn more about registered accounts, check out some of these pages: Registered Accounts in Canada – What you Need to Know Tax Free Savings: TFSA Traps to Watch Out For RRSPs FHSAs RESPs