Why Canada’s TFSA Is Totally Awesome

In a recent article, I compared the Canadian and American retirement systems, and while I tried to include as much as I could, a lot of people jumped on my omission of the Tax Free Savings Account (TFSA). I left it out because, strictly speaking, a TFSA is not a retirement savings vehicle. But I should’ve included it anyway for one simple reason — TFSAs are totally awesome, especially for investors. That’s because if you put your investment in one of these, you don’t have to pay capital gains tax. For regular people, that’s as close as you can get to the benefits of an account in some tropical, offshore banking center (which, let’s face it, probably wouldn’t be interested in a $3,000 deposit anyway).

According to a poll released by the Bank of Montreal in November, about 38% of Canadians have a TFSA account. If you aren’t in that group, you’re missing out. Here I’ll go over this relative newcomer to Canadian financial (and yes, retirement) planning.

TFSA 101

First things first — the TFSA is poorly named and, as a result, many people assume that it’s a savings account. In fact, the TFSA isn’t an account at all; it’s more like a label that can be applied to all kinds of financial accounts, including regular savings accounts, stock trading accounts, mutual funds, bonds, and even certain types of small business shares. In other words, it isn’t just for saving. In fact, the TFSA’s tax-free capital gains mean you get the greatest advantage by using it to invest. Unlike virtually every other kind of account you could put your money into, if you use a TFSA, you won’t have to pay tax on any interest, dividends or capital gains you earn. Ever.

Of course, there are some limits. When the TFSA was introduced in 2009, every Canadian over the age of 18 got $5,000 of contribution room. Like a Registered Retirement Savings Plan (RRSP), this contribution room continues to accumulate each year, and remains open whether you use it or not. So, if you’ve never contributed to a TFSA, you could deposit as much as $25,500 in 2013 (the contribution was increased to $5,500 this year). Plus, that contribution room never goes away, even when you spend the money, which you can do without penalty whenever you choose. You could sock some money away for your retirement or pull it out and spend it on a nice vacation. Your choice. And hey, if you do manage a solid capital gain during the year, it might just be a very affordable trip!

Tax-Deferred Versus Tax-Free

What many people don’t understand about TFSAs is the tax implications, which explains why, according to the BMO poll, many people don’t use them effectively. So here’s a rundown.

TFSAs are tax free. That means that if you contribute $5,500 this year, make a great stock pick, and end up with $10,000 in your account by the end of the year, you can avoid paying what would normally amount to $675 in capital gains tax (assuming a 30% income tax rate). Pretty sweet, right?

Now take the RRSP. If you contribute $5,500 to this type of account instead, you can deduct that $5,500 from your taxable income, which could mean a tax refund. So, essentially, the money you contribute to an RRSP has not been taxed. However, if your contribution grows to $10,000, you will pay income tax on that amount when you withdraw it (which hopefully happens when you’re retired). The logic behind deferring your taxes until retirement is that many people have less income during retirement, and therefore a lower tax rate.

Why the TFSA Is Totally Awesome

What really sets the TFSA apart is that it’s flexible. You can use it to save money for short-term goals, or to save for longer term dreams like a new home or even retirement, and you withdraw that money whenever you want. Plus, if you’re already maxing out your RRSP, a TFSA gives a little extra incentive to save more. For those with lower incomes who might not benefit from an RRSP’s tax deduction, it also provides another option.

Whether you’re making big bucks trading stocks and other investments or just racking up a little interest, a TFSA means you won’t have to pay taxes on those gains. In other words, a Tax Free Savings Account is about as close as you can get to a free lunch in the investing world. And what budget-savvy person ever turns down one of those?

This post was made possible by support from Standard Life, a leading provider of Canadian pension plans