Get excited savers! A new year means more Tax Free Savings Account (TFSA) contribution room. Here are a few facts about the TFSA and how you can benefit from this magical account.
The Tax-Free Savings Account (TFSA) is a flexible, registered, general-purpose savings account* that allows Canadians to earn tax-free investment income. The TFSA complements existing registered savings plans like the Registered Retirement Savings Plan (RRSP) and the Registered Education Savings Plan (RESP).
How the TFSA works:
- As of January 1, 2013, Canadian residents, age 18 and older, can contribute up to $5,500 annually to a TFSA. This was a hike from the annual contribution limit of $5,000 for 2009 through 2012.
- Investment income earned in a TFSA is tax-free.
- Withdrawals from a TFSA are tax-free.
- Unused TFSA contribution room is carried forward and accumulates in future years – hence, Happy New Year!
- Full amount withdrawals can be put back into the TFSA in future years. Re-contributing in the same year may result in an over-contribution amount which would be subject to a penalty tax.
- Contributions are not tax-deductible.
- Neither income earned within a TFSA nor withdrawals from it affect eligibility for federal income-tested benefits and credits, such as Old Age Security, the Guaranteed Income Supplement, and the Canada Child Tax Benefit.
- Funds can be given to a spouse or common-law partner for them to invest in their TFSA.
This is MUCH more than a general-purpose savings account*
The main advantage of a TFSA: tax-free growth and tax-free income earned inside the TFSA. So let’s look at some great investments ideas that could help you out, far beyond general-purpose savings.
1. Canadian Dividend Paying Stocks
Canadian dividend-paying stocks receive favourable tax treatment from our government; they are eligible for the Canadian dividend tax credit if left unregistered (outside TFSA and RRSP accounts). But we are talking about the TFSA right? We are, so Canadian dividend paying stocks will lose the dividend tax credit inside the TFSA but you’re still getting tax free dividend income inside the account for as long as those companies pay dividends. It’s not inconceivable that an investor who has maxed out their TFSA every year since inception with some selected blue-chip Canadian dividend paying stocks could have a TFSA value close to $50,000 by now, churning out tax-free dividends.
2. Canadian Real Estate Investment Trusts (REITs)
Canadian REITs are companies that invest in real estate assets and distribute their income (primarily from rent) to shareholders, usually in the form of dividends, return of capital, and income. While it depends on the REIT, if the REIT distributes a portion of their income as return of capital, interest, capital gains or dividends, each portion will be taxed accordingly. Keeping REITs inside a TFSA avoids this tax complication. Many Canadian REITs are yielding more than 4% right now and you could expect (although nothing is ever guaranteed with any investment) some capital appreciation over time as well.
3. Canadian Exchange Traded Funds (ETFs)
An Exchange Traded Fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. An index is a group of stocks or bonds used to measure the performance of a particular market – such as the S&P 500 stock index – you’ve probably heard of that one. Not all indexes are created equal though.
So what are the benefits of ETFs, specifically those that track a broad market equity index? Here are a few:
- Index-like returns
- Income in the form of distributions
- Easy to buy and hold using your discount brokerage account.
It’s not inconceivable that an investor who has maxed out their TFSA every year since inception with ETF XIU or XIC, wouldn’t be far from a portfolio value of $50,000 by now without any stock selection or headaches in doing so. FYI: The 5-year returns of XIU and XIC at the time of this post are both just over 7%.
Honourable mention goes to…
You might already know this but it’s worth mentioning there are 15% withholding taxes on U.S. stock dividends paid inside a TFSA. You can’t recover these withholding taxes. However, what about British stocks traded on the New York Stock Exchange (British American Depositary Receipts (ADRs))? (Note: an ADR is a stock that trades in the United States but represents a specified number of shares in a foreign corporation. ADRs are bought and sold on American markets just like regular stocks; issued by a bank or brokerage). For many British ADRs there are no withholding taxes charged inside the TFSA.
The Best Bet
Most investors are best to avoid any stock market speculation and simply invest in low-cost indexed funds for the long-run. My suggestion is to consider your TFSA much more than a general-purpose savings account. Your future self in retirement will thank you.
Do you consider your TFSA as a savings account or a retirement account? Share your story in a comment.