When the Conservative government introduced the Tax Free Savings Account (TFSA), it became one of the best savings tool introduced to the Canadian population. If you don’t have a TFSA account, then you should stop reading this blog, run out to your local financial institution and set one up right away.
So what’s so great about the TFSA account? Good to its name, it means that whatever money you make from investments in a TFSA is not taxed by the government. Wow! No tax you say?
Of course, such a good thing doesn’t come without restrictions. The government imposed a maximum contribution of $5000 per year that can be made into the account and accumulate for every year that the account has been opened. This amount would rise according to inflation, rounded to the nearest $500 increment. After 5 years of existence, the limit has finally been raised to $5500 in 2013. That’s great news for everyone! On top of that good news, anyone who opens an account right now can contribute the full $25500 amount, as the accumulation is retroactive to when the TFSA was first introduced. This holds true for now, but I wouldn’t guarantee that a few years down the road, one of the governments will stop letting that retroactive date happen. Why’s that? Well think of all the tax revenue the government is losing if everyone can put away $25k+ and never get taxed on the gains. So if you don’t have an account, go get one now and let that contribution level grow each year.
The TFSA is not your regular chequing or savings account. Its purpose is not to do your regular banking transactions, such as paying your bills or using it for debit card purchases. Primarily the TFSA is used as a long term savings account for retirement. The reason why you shouldn’t consider the TFSA for regular transactions is because there are rules governing how withdrawals and contributions can be made. The contribution limit on the TFSA is very strict and those that don’t follow it will incur a hefty penalty (1% interest penalty per month you are over). The government doesn’t want you to put all your money away in a tax-free account. They would get no tax revenue!
To understand how withdrawals impact your TFSA contributions, consider the following. You put $5500 into the TFSA in 2013 and you end up taking out $1000 for emergency purposes. You cannot put that $1000 back into the TFSA during 2013. The government will consider that as a contribution of $6500 for the year. Subsequently, you will get charged an interest penalty for that $1000. So when can you put that money back in? The answer to that is next year, 2014. Since $1000 was taken out in 2013, that money is added to the limit for 2014. That makes your contribution limit equal to $6500 for 2014. The rule to remember here is that any amount of money you take out of the TFSA will be added to your limit for the following year.
Whew. We got all those tough rules out of the way, but seriously what benefits does a tax free account really give me? To take a look at this, let’s consider this situation.
- You invest $1000 in a GIC paying an annual interest of 1.5%
- At the end of the year you get $15 of interest paid to you
- That $15 is taxable at your marginal income tax rate in Canada
- If you make $45000 in Ontario a year, $3.30 of that would go to Federal tax, another $1.37 would go to Provincial taxes
- Your real income after all taxes would be $10.33 in interest payments
(Taxation values can be found on the CRA site)
In that above example you would have lost almost 1/3 of your income to taxes. If the bank paying you 1.5% interest on your $1000 isn’t bad enough, the government comes and takes even more away.
Well what would investing the $1000 in the TFSA do? Well you get to keep the $15.00. No taxes paid. No extra deductions. Nada!
After reading all this you’re wondering. Who cares? Why does it matter? I get nothing out of my GICs anyways. What difference would a few bucks make. What most people don’t know is that the TFSA can be used to make all sorts of investments. Mutual funds, stocks, and bonds, these can all be purchased in a TFSA and would garner you more income. We’ll discuss these financial instruments in another column. For now get out there and get yourself a TFSA account!