One of the most common questions I get as a wealth advisor is: “Which type of retirement account should I put my money into…an RRSP, which is a Registered Retirement Savings Plan, or a TFSA, which is a Tax Free Savings Account? Which one should you put your money into?
There’s a good reason why there’s so much confusion around this, and that is because the answer is going to be different for everyone. It depends on your income, your age and other things. Ideally, you would be contributing to both an RRSP and a TFSA, but few people have that kind of income. If you need to choose between the two, here’s a general guideline: if you’re still working and your income and taxes are high and you have many years before your 71st birthday, an RRSP is your best bet. If you earn less than $40,000, your income tax is likely lower and you’re probably better off investing within a TFSA.
Now, here’s an interesting fact... Do you know which age group of Canadians utilizes the TFSA most often? It’s those over the age of 75. Their average TFSA balance is close to double the national average of $32,000. That’s because the Tax Free Savings Account is one of the most powerful tools to create tax efficient income in retirement that we have in Canada.
So, today, let’s talk about Five Ways to Get the Most from your TFSA.
Let’s start with some basics. Why is it called a Tax Free Savings Account? Let’s say Sandra puts $5,000 into her TFSA. She invests the $5,000 wisely and it grows over time. Now it’s worth $10,000 and she wants to start withdrawing money out of it to live off of. Let’s say she takes $500 out. Does she have to pay tax on that $500? No, she doesn’t. She doesn’t pay one penny of tax on that income!
I know, right?
Now let’s see what would happen if she had deposited that $5,000 into an RRSP. The year she made the deposit, she will reduce her taxable income by $5,000. That’s great, and did NOT happen when she put the money in her TFSA.
But what happens when she takes out that $500 in income from the RRSP? Would she have paid tax on it? Yes. And that’s the beauty of a TFSA and why it’s so important in our income planning when we’re retired. We don’t get any tax benefits up front, like you do with an RRSP, but it sure makes a difference down the road.
Another great feature of the TFSA is that the amount of money you can put in is cumulative over the years. Every year around tax time, the federal government will announce how much money you can put into your TFSA. Let’s say Ashley turned 18 years old in 2021. The Federal Government says she could have deposited $6,000 for that year. But maybe she didn’t have $6,000 to deposit that year. So she doesn’t deposit anything.
Now it’s May 2022. Ashley just received a gift of $12,000 from her grandparent, and the Federal Government announced she can deposit $6,000 in 2022, so she can deposit $6,000 that she still has available from 2021 and the $6,000 she’s allowed to deposit this year, in 2022. She can play catch up. We call this cumulative amount the contribution room, and if you don’t use it, you don’t lose it, you can catch up later.
That can add up to a lot of money as time goes on. The TFSA has been around since 2009, so if you were born in 1991 or before, and have never deposited money into a TFSA, you can deposit $81,500 as of June 2022 and never have to pay taxes on money you withdraw from that account.
You may be thinking, this TFSA thing is great, can I open one for my young children or grandchildren so they can really get a head start? The answer is no.
A TFSA is structured in a way that requires legal consent of the owner of the account, so that means most financial institutions will require your child or grandchild to be a legal adult before they can open an account. In most provinces, that’s age 18 but in others, such as British Columbia, you must wait until 19 years of age to open the account.
But the good news is, when you open the account at age 19, you can deposit the amount for that year AND the amount you were allowed to deposit the year you turned 18. You start accumulating those credits when you turn 18 anywhere in Canada, you just can’t open an account and start depositing it until you’re of legal age.
What you could do for your child is open an ordinary investment account for them when they’re young and give them ownership of that investment account when they become adults so they can use that account to start transferring money from it to make deposits into their TFSA later. So, that old investment account may have built up to $20,000 by the time they’re an adult. Your child can transfer $6,000 this year into their newly minted TFSA transfer next year’s allowable contribution amount into the TFSA and so on.
Now that we know what the TFSA is and how it works, let’s move on to the Five Ways to Get the Most from your TFSA.
The first way is to realize a TFSA is an investment account, not a savings account.
Let me back up here a bit.
Many people mistakenly think a TFSA or an RRSP are investments in and of themselves. They are not investments. They are baskets that hold investments. Think of it this way, I like to use baskets to organize things at home. I might have two baskets that hold Bandit’s toys. One is green, the other blue. The baskets are different but they both hold Bandit’s toys. An RRSP is a different basket, a different account from a TFSA, but they both hold investments inside of them. A TFSA is an account that holds investments tax-free.
Because it’s called a Tax Free Savings Account, many people think you can only open it at a bank and you can only hold cash inside of it that is earning interest. If you’re going to be taking money from your TFSA to make a purchase in the next few years, like for example, using it as a down-payment on a house, you should be investing only in a savings account within your TFSA basket. But if you’re not going to be pulling money out for a long time, you want to be investing in things like mutual funds and ETFs that invest in stocks and bonds.
Investments that will earn you a lot more money, tax free, over time. You want to earn as much as you can for as long as you can because you’re not going to have to pay tax on it.
Another great way to use your TFSA is for any windfalls you may receive.
One of the best things about a TFSA is that it continues to be a great tool long after you are retired.
My client, we’ll call her Geri, owned a rental property that she had planned on giving to her daughter after ten years. As it turned out, her daughter moved to another country and wasn’t really interested in becoming a landlord for a Canadian property. So Geri and I made a plan to determine what was the best way for her to deal with this property.
Geri was going to be retiring in a few years and had owned this rental property for a long time. She knew she wanted to have fewer obligations when she retired. The responsibilities of a rental property didn’t appeal to her anymore. She wanted to sell it in 5 years.
To plan for this windfall from the sale of her rental property we did a few things: One, we worked with her CPA to determine what the proceeds would be from the sale of the rental property. Then, we calculated how much tax we could reduce if we made a large contribution to her RRSP that same year that she sold the property. Lastly, we made a plan to put the rest of the proceeds into her TFSA.
Remember, though, she has a limit to the amount she can put into her TFSA each year. Since we knew she wasn’t selling the property for a few years, we determined that the best plan was to not contribute to her TFSA for a few years before she sold the property. That would allow us to put all the after tax proceeds of the sale of her rental property into her TFSA.
The result was that she turned an investment that she was having to pay tax on, the rental income she received, into an investment she didn’t have to pay tax on, because it will be held in her TFSA.
And, since Geri liked investing in real estate, we invested the money into mutual funds that invest in real estate. The next way to make the most of your TFSA is to keep track of the withdrawals and contributions you make throughout the year.
Think of your TFSA as a business that requires bookkeeping.
If you’ve done the smart thing and maxed out your contributions over the years, you need to be careful. If you make a deposit into your TFSA and later make a withdrawal from it that same year, you could be penalized by the CRA.
For example, let’s say you are planning on buying a home. You are just about to close on the home so you withdraw $50,000 from your TFSA for part of your down payment. Suddenly, the deal falls through and you decide this is not the best time to buy a house, you’re going to wait a few years. So, being the diligent investor you are, you deposit the money back into your TFSA.
You now have made both a withdrawal of $50,000 and a contribution of $50,000 in the same year. Because you have been a good investor and maxed out all your past year contributions, you have now over contributed to your TFSA by $50,000 and the CRA is going to penalize you every month the money stays in there.
How can you avoid this? It’s actually very simple. If you wait until January 1st of next year, you can put the money back in without being penalized. That’s because the CRA allows you to redeposit any withdrawals you took out as long as you don’t redeposit it the same year you withdrew it.
So, it’s very important to keep track of your withdrawals and deposits. Don’t rely on your wealth advisor or your bank or even the CRA to keep track of your TFSA contribution room during the year. They don’t have the complete information, only you do. For one, the CRA updates their information only once a year, around tax time. As for wealth advisors and banks, we only have information on the accounts you hold with us. If you have accounts elsewhere, we have no information on any deposits you might have made there. So be sure to keep track of all the ins and outs yourself.
Here’s a super tip: If you have a TFSA sitting at a bank right now and want to move the money over to a wealth advisor to invest it for you, do not withdraw the money from your bank TFSA and then walk it over to the wealth advisor to deposit it.
That will count as both a withdrawal AND a deposit in the same year, which we don’t want to do. Instead, ask the new wealth advisor to transfer the money into your new investment account and they will handle it all for you. That way it won’t count as a contribution OR a withdrawal.
We Canadians are a globe-trotting bunch. Not to mention, given the opportunity to work for our neighbours to the south, many of us will take it.
If you’re thinking of spending a year or more away from Canada, you should understand the residency requirements of a TFSA.
If you become a non-resident of Canada, you can keep your TFSA invested but you may forever lose the contribution amount available to you for some or all of the time that you are gone.
The important thing to plan for here is: will the CRA consider you to be a non-resident? And they have criteria to determine this. For example, if you are living in another country, working in that country and not filing taxes in Canada, you’re probably a non-resident. But if you are retired, own your primary home in Canada and have a Canadian drivers licence but are just taking an extended vacation, you are probably fine.
But, before you plan your trip, check with your tax advisor to determine if you will be considered a non-resident of Canada while you’re gone and if so, when is the most tax advantageous time for you to leave Canada.
Let’s go back to our friend, Ashley. Let’s say Ashley is planning on working in the US. She leaves for Seattle February, 2018, lives and works there a few years and returns December, 2021. So, she left in 2018 and comes back in 2021.
During that time, the government announced that the maximum TFSA contribution allowed for 2018 was $5,500 and $6,000 each for 2019, 20 and 21.
She plans to leave Canada in February, 2018. The rules say that, because she was a resident for at least part of 2018, she gets to add that $5,500 contribution to her TFSA either before she leaves the country or after she gets back.
She comes back in December, 2021. That’s another partial year in which she became a resident again. So she gets to add the 2021 contribution of $6,000 to her TFSA when she returns.
But, she was a non-resident for all of 2019 and all of 2020. She was working and living abroad, not filing taxes in Canada. So she loses the ability to add the $6,000 available to her for 2019 and the $6,000 available to her for 2020. She can never get those back.
What if she decided not to come back in December 2021 and instead came back in February, 2022? She would also lose the $6,000 contribution available to her for 2021 as well. So, you can see how important it is to plan your time away.
If you have a spouse or common law partner, be sure to have your wealth advisor list each of you as Successor Holders instead of Beneficiaries.
Why? Less tax and less red tape. If you’re the beneficiary, you will get the money in the account. If you’re the successor holder, you become the new owner, so you receive both the money AND the rights to the account. Here’s what I mean.
Let’s say Denise has a TFSA and she passes. She made her husband, Jim, her successor holder. Immediately upon her death, Jim becomes the owner of her TFSA account. He receives the money tax free and can have his wealth advisor merge the two accounts together into one and this event doesn’t use up any of Jim’s TFSA contribution room. The whole transaction was automatic and simple and Jim pays no tax by receiving the money or investing it going forward.
What if Jim was listed as beneficiary instead of successor holder? In that case, Jim will still receive the money from the account tax free from Denise. But, from the day Denise passes until the day Jim finally gets a chance to deposit the money into his own TFSA, Jim will owe taxes on that inheritance unless he files certain paperwork with the CRA and meets certain deadlines. It creates unnecessary stress and work for Jim at a time when he should be caring for himself and grieving.
If you are leaving your TFSA to someone other than your spouse, you will always name them as a beneficiary and in their case, they can only roll over the inheritance into their TFSA if they have contribution room available.
But if you have a legal or common law spouse, check with the financial institution where you hold your TFSA account and ensure you’ve designated them as a successor holder.
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