The Tax-Free Savings Account
The TFSA can be a very powerful tool for wealth generation. Investment income earned inside your TFSA (interest, dividends, and capital gains) do not create an income tax liability. Gains are truly tax-free.
The aggregate contribution limit since the plan opened in 2009 is now $81,500 per person, and by January 2023, it will increase by an additional $6,500 per person up to an $88,000 aggregate limit. This means that by January 2023, any household where both spouses were born in 1991 or earlier can shelter up to $176,000 in direct contributions to the plan.
With so many attractive features, we prefer to think of the TFSA as a tax-free investment account, and not a ‘savings’ account.
Here are some tips and potential pitfalls to be aware of.
TIPS:
TFSA room is granted on January 1st of the new year, therefore maximize tax free compounding by contributing as early as you can every year.
Use the TFSA to tax-shelter investments likely to result in the highest amount of income tax liability.For example, foreign dividends (although not U.S dividends) and interest income.
Create a tax-free source of income from the account when it’s best for you. TFSA withdrawals won’t impact OAS benefits and won’t affect government income-tests (like government-subsidized independent living).
Create and grow a tax-free legacy. For simple estates and where advisable, the TFSA beneficiary designation can be used to pass an inheritance to your children quickly.=
Name your spouse as successor holder instead of beneficiary and easily retain your combined tax-free contribution room when the first spouse passes.
Pitfalls to Avoid:
If possible, avoid holding US dividend paying securities in your TFSA. The IRS does not recognize the account and will apply withholding taxes that you can’t reclaim.
Avoid sheltering investments with low yield and low return potential in the TFSA.
Don’t overcontribute as you’re taxed 1% per month on the overcontributed amount. The TFSA limit is per person, not per household. Check your online CRA portal for contribution room and history. Sometimes contributions made late in the previous calendar year aren’t posted to your CRA portal for a few months, indirectly leading to an accidental overcontribution.
Avoid the TFSA if you’re a US citizen. It’s likely to be more hassle than benefit as the IRS does not recognize the account. It will increase the complexity of your IRS filing.
Don’t overtrade in the account. The purpose of the account is for long term investing, and a lot of trading could lead to the CRA to taxing your gains at regular income levels.
Be careful with speculative securities. There are no capital losses if an investment does poorly, and you could permanently impair your TFSA room if a speculative stock zeroes in value.
Although the TFSA won’t make you immortal, it does provide a legitimate reprieve from at least one of life’s certainties: taxation.
