What is a TFSA? 5 Common TFSA Questions Answered

The results are in: Canadians still don’t know what TFSAs are.

According to a recent poll by CIBC, half of Canadians don’t even know how to use a TFSA. You’d think that in the six years since they were introduced, we’d have figured it out. Well, enough is enough. Below are the answers to five commonly asked TFSA questions once to set the record straight. By the end, you’ll be able to wow your friends with your TFSA knowledge and should feel much more confident about using them to reach your savings goals.

1. Are TFSAs just savings accounts?

If I were asked about TFSAs and I knew nothing about them, the conversation would probably go something like this:

“Hey Lloyd, what’s a tax-free savings account?”

“Uh. Isn’t it a savings account that’s, like, tax-free?”

Wrong.

That logic may work sometimes, but the unfortunate truth is that the name “tax-free savings account” is misleading. (Thanks, federal government!) So let’s get it straight right now: TFSAs are NOT savings accounts.

Let me explain. A TFSA is just a tax shelter for your investments. Like a tax-resistant umbrella, it protects investments from tax, allowing them to grow tax-free. And you can put much more than just cash savings under this umbrella, which leads us to another commonly asked TFSA question:

2. What can I hold in my TFSA?

CIBC found that 50% of Canadians are unsure what they can hold in a TFSA. This is pretty shocking and it likely stems from the confusion around the question above. But now that you know a TFSA is simply a tax shelter, it’s simple: virtually any investment—GICs, bonds, stocks, mutual funds, and even savings accounts—can be held in a TFSA. Place them under the TFSA umbrella and they’ll be safe and dry from the storms of taxation.

Wait a minute. Isn’t that the same as a Registered Retirement Savings Plan (RRSP)? I’m glad you asked.

3. How is a TFSA different than an RRSP?

This is another question a lot of Canadians wrestle with. Since they are both tax shelters, RRSPs and TFSAs do have a lot of similarities. But there are key differences that make each one advantageous in different situations. Here are some important features to keep in mind:

RRSPs vs. TFSAs

• Both RRSPs and TFSAs have the ability to shelter a variety of your investments (and any income earned by them) from tax.
• RRSP contributions are deductible on your income tax, meaning you’ll get a nice tax break right away. TFSA contributions, on the other hand, are not tax-deductible.
• Finally, when you withdraw funds from an RRSP, those funds will be taxed as income at your marginal tax rate. With a TFSA, you can withdraw funds at any time, tax-free.

So, which one should you use for your savings? There are a lot of theories on which one to use for the best tax benefits—the best strategy will always depend on your current financial situation—but one basic rule holds true: your choice should be dependent on your savings goals.

RRSPs are designed to help you save for retirement and, for this reason, they work very well for long-term savings goals like retirement. You can plan to withdraw RRSP funds when you’re retired and in a lower income tax bracket.

TFSAs, on the other hand, are appropriate for any savings goal and work particularly well for shorter-term savings goals. Whether you’re saving up for a car or another big purchase in a few years, you can rest assured that you can withdraw your money at any time without paying taxes on those funds.

4. What’s the deal with contribution room?

This is another big one. As CIBC also found in their poll, a large percentage of Canadians are confused about TFSA contribution room. Some pretty hefty fees are applied if you go over your limits, so it’s important to get this right. Here are the basic facts to remember:

• Unused contribution room carries over to subsequent years. This means that you accumulate more room after every year you were eligible. So, if you were 18 or older when TFSAs were introduced, you have $41,000 of contribution available to you today (that is, if you haven’t used any up yet).
• Investment income earned within your TFSA actually expands your maximum contribution room. The sky is the limit here. In fact, a former Bay Street trader managed to grow his TFSA to $1.25 million!
• When you withdraw money from your TFSA, you can replace it. But be careful—withdrawals are only added back to your TFSA contribution room at the beginning of the following year. A simple rule of thumb that will keep you safe and avoid complications: if you make a TFSA withdrawal, don’t put the money back until next year.
• Over-contributing to your TFSA comes with some fees. The penalty is a monthly 1% tax applied to every dollar that exceeds your contribution room. It may not sound like much, but this can really add up, and it eats away at any tax savings you might have had.

5. What investments work best in a TFSA?

Finally, many Canadians wonder what investments are best suited for a TFSA. If you have more room, any investment will of course be better off if it’s sheltered from tax. But if you plan to use all of this room, you’ll need to prioritize. Here’s are some suggestions:

• TFSAs are great if you need access to your funds, since withdrawals are tax-free.
• TFSAs work well for investments with interest income, since interest is subject to higher tax rates compared to dividends and capital gains; (capital gains are income earned from stocks). This would include investments like GICs and bonds.
• Higher-risk, higher-reward investments are also good candidates for TFSAs. That way, if you luck out with a great return, this income will be sheltered from tax.

If you were one of the many Canadians confused about TFSAs, hopefully this gave you the confidence to dive in. Now put this knowledge to work and save some money!

What other questions do you have about TFSAs? How do you plan to use TFSAs to save money? Let me know in the comments section below or tweet us @RateHub!

Flickr: Pame Figueroa