Looking to save money as one of your New Year’s Resolution? Here’s some good news: as of January 1, 2019, the Canadian government raised the annual TFSA limit to $6,000, up from $5,500 last year. This increase means that Canadians who were at least 18 years of age in 2009 now have a cumulative maximum of $63,500 in TFSA contribution room — a significant chunk of money that can deliver tax-free compound earnings over time.
A Tax-Free Savings Account (TFSA) is a great place to stash your cash and meet your money goals, but there are few things to understand before you get started saving. Here’s what millennials should know about TFSAs, the increase in the TFSA contribution limit to $6000, and how a TFSA can help you achieve your financial goals.
What is a TFSA?
Created in 2009, TFSAs are a registered savings and investment vehicle that offer special tax benefits. You can hold virtually any type of savings or investment account within a TFSA, including cash, GICs, mutual funds, stocks and bonds. The income earned in these accounts — bank interest, dividend payments, equities growth, etc. — is completely tax sheltered. You never pay tax on those earnings, which means they compound tax-free over time. You also don’t pay income tax when you withdraw funds from your TFSA.
TFSAs are gaining popularity among younger Canadians. According to the latest census data, about 40% of those under than 35 have a TFSA, making it the age group’s preferred registered savings vehicle.
Should I Contribute to a TFSA?
For most millennials, the answer is a resounding yes. If you have money parked in a regular high-interest savings account, or you have any non-registered investments such as GICs, stocks or bonds, you can avoid paying tax on the interest or investment earnings by simply transferring those savings or investments into a TFSA.
This tax sheltering is particularly beneficial as the TFSA contribution limit increases. For example, if you got a 5% annual return on a $5,000 contribution in 2009, you’d have earned $250 within one year, and avoided somewhere between $37.50 and $82.50 in income tax on those earnings (depending on your income tax bracket).
But if you now have the cumulative limit of $63,500 invested, at the same rate of return you’ll make $3,175 tax-free within a year, saving you somewhere between $476.25 and $1,047.75 in income tax (depending on what your total income and tax bracket is).
How to Choose the Best TFSA Savings Account
Selecting the right TFSA depends on how you plan to use your savings. According to a BMO poll, about 50% of Canadians use a TFSA for retirement savings and 39% use it as an emergency fund. If you might need to use the money in your TFSA within the next five years, like an emergency fund, or for buying your first home, an upcoming wedding, car purchase or other upcoming expense, a high-interest savings account or GIC could be the right type of TFSA for you.
However, if you plan on leaving your TFSA money to grow over the long term, such as for retirement, a balanced and diversified investment account will offer you the highest returns, as we explain below.
Current TFSA Contribution Limit
There is an annual limit you can contribute to a TFSA for each year that you were 18 or older. Unused room can carry over to a 2019 cumulative TFSA contribution limit of $63,500, as follows:
So if, for example, you turned 18 before 2009 and have never contributed to a TFSA, you now have the full cumulative contribution limit of $63,500.
If, on the other hand, you turned 18 in 2010 and previously contributed $15,500 to a TFSA, you would now have $43,500 of remaining contribution room:
$63,500 cumulative TFSA limit
– $ 5,000 (ineligible age in 2009)
– $15,500 previous contributions
=$43,000 available contribution room
One caveat: once you’ve used up your available contribution room, any withdrawals you make from your TFSA cannot be paid back into the account until the following year. If you mistakenly overcontribute to your TFSA, you’ll pay a tax of 1% on the excess amount for each month that it remains in your account.
For example, if you maxed out your TFSA in early 2018 and then withdrew $5,000 in September of that year, you’d have had to wait until this January 2019 before you could pay back those funds (or you’d be charged the penalty). On Jan. 1, 2019, your available contribution room would then be $11,500 ($6,000 for 2019 + $5,000 repayment of the 2018 withdrawal).
How to Invest in a TFSA
At Young and Thrifty, we recommend taking the couch potato approach to investing, also known as passive investing. Over the long term, this strategy provides the greatest returns with the least risk because you aren’t chasing the latest stock tips trying to beat the market, and you avoid the high fees charged by most Canadian mutual funds.
By purchasing extremely low-fee investments that track the performance of the market overall, such as exchange-traded funds and index funds, you will maximize your earnings.
You can use the couch potato strategy to invest in any type of account, including non-registered accounts, Registered Retirement Savings Plans and TFSAs.
To start a couch potato portfolio within a TFSA, you have several options:
- Open a TFSA account with an online discount brokerage, such as Questrade or Virtual Brokers, to buy low-fee ETFs
- Open a Tangerine Tax-Free Investment Fund, which is a balanced portfolio of index funds to match your risk profile
- Open a TFSA account with a robo advisor, such as Wealthsimple, Questwealth Portfolios, BMO Smart Folio, Wealth Bar, Nest Wealth, Justwealth, and Planswell, so you can choose a pre-fab portfolio of ETFs that matches your risk profile
RRSP vs. TFSA?
The main difference between an RRSP and TFSA is how and when you are taxed on contributions and earnings. With an RRSP, you get the benefit of a tax deduction for your contributions in the year you make them, and your investments grow tax-free while inside the RRSP. But you must pay income tax in the year you withdraw funds.
With a TFSA, there is no tax deduction when you contribute, and your investments grow tax-free while inside the TFSA. The real benefit comes when you withdraw the money – completely tax-free.
Other differences include annual contribution limits and age restrictions for contributions, as shown in the chart below.
|Annual contribution limit||$6,000 (as of 2019)||18% of previous year’s earned income (up to a max.of $26,500 for 2019)|
|Ages you can contribute||18 and over||Up to age 71|
|Get a tax-deduction in year of contribution?||No||Yes|
|Pay income tax in year of withdrawal?||No||Yes|
Ideally, you want to contribute to both TFSAs and RRSPs to get all the tax-sheltered earnings allowed. If you cannot afford both, a TFSA is often a better choice for younger Canadians for two main reasons:
If you are saving up for a house, car, vacation, wedding or any other pre-retirement big ticket item, money in a TFSA can be easily withdrawn at any time tax-free and without penalty. Plus, you can replace any money withdrawn from the TFSA in the following calendar year.
On the other hand, if you withdraw money from an RRSP pre-retirement, you’ll incur significant fees and income taxes. There are a couple of exceptions, such as the Home Buyers Plan and Lifelong Learning Plan, that allow you to withdraw money from an RRSP to help pay for a home purchase or education costs — but even then there are strict parameters on how much you can withdraw without penalty, and when you must repay the funds into your RRSP.
2) Canada’s progressive income tax system
Even if you’re sure you won’t use the money until retirement, a TFSA can still be a better choice for younger Canadians who expect their incomes to rise in the future. Why? Because you get a tax deduction when you make RRSP contributions, and you’ll save more money on taxes if you keep your RRSP contribution room open until your income rises and puts you in a higher tax bracket.
Tax-free savings accounts are an important tool for achieving your financial goals by minimizing the tax you pay on interest and investment earnings. Whether you choose a high-interest savings account, pre-fab portfolio of index funds or ETFs, or build your own portfolio using a discount brokerage, you can shelter your money’s earnings from tax and maximize your money.