Although they are almost five years old, many Canadians are still confused about the rules and benefits of Tax-Free Savings Accounts.
Tax shelters are few in Canada, so it's important to understand the ones that are available. The introduction of the Tax-Free Savings Account (TFSA) in 2009 was met with positive feedback, but it seems Canadians are not always sure about its value. The Canada Revenue Agency (CRA) reported that only eight million of Canada's 35 million tax filers had a TFSA in 2011. It is hard to explain that low percentage but, in my experience, there are still many people who don't understand how a TFSA works. Here are some common myths:
I already have an RRSP, so I don't need a TFSA. These are two very different accounts, and designed for very different purposes. A Registered Retirement Savings Plan (RRSP) defers taxable income until retirement, when your income is smaller. A TFSA allows you to accrue interest on savings without paying tax on the interest. It doesn't affect taxable income.
I don't want my money locked up in case I suddenly need cash. TFSA contributions aren't locked up. Unlike RRSPs, there's no tax penalty for withdrawing money from your TFSA, but withdrawals affect whether you can make additional contributions to your TFSA during the year. The important number is not the balance of the account, but the aggregate amount you contribute during the year. The annual limit was raised in 2013 to $5,500 from $5,000; if you contribute more, there's a tax penalty. So if you've already put $5,500 into a TFSA and withdraw $2,000 for emergency car repairs, you can't put that money back into the account this year. However, because unused contribution room does carry forward, you can replace that $2,000 next year.
I don't have enough money to open a TFSA. There's no minimum contribution, no minimum balance. The more, the merrier, of course, since you'll be earning more tax-free interest. And you can withdraw from it without penalty as long as you follow the contribution rules. If you have less than $5,500 in a traditional savings account, you may want to consider a TFSA.
Interest rates are so low, there's no real advantage to a TFSA. Any bank account interest, other than a TFSA, becomes taxable income when it reaches $50 in a year. Even at an interest rate of one per cent, a $5,500 savings account would accrue enough interest to be taxable. And as you contribute year over year, that amount only gets larger.
Still, savings account interest rates are so low. Financial institutions are offering a variety of TFSAs, some as conservative as a traditional savings account, some much more aggressive. A TFSA that earns only interest is safest, but $5,500 in an account returning 1.5 per cent only generates $82.50 in non-taxable interest. More aggressive accounts are available, but just as you don't have to report the higher interest it might accrue on our tax return, you can't claim TFSA losses, either. Taking on more risk could mean a greater return, but make sure you are comfortable with the account option you choose.
The balance will affect my eligibility for programs like the Canada Child Tax Benefit and HST/GST credits. The balance in your TFSA has no effect on your taxable income, nor do your contributions as long as you stay within the limits. There's no immediate tax benefit from a TFSA, and it doesn't impact your taxable income.
I have enough money management headaches already. I don't need the complications. Actually, this is one of the simplest investments you ever make. There's only one number you need to track: how much you've contributed during the calendar year. But it is your responsibility - not the bank's, not the CRA's - to make sure you don't over-contribute. You can access your TFSA contribution limit through My Account. If you do exceed the limit, you'll be charged one per cent of the excess amount per month. But you can request a waiver of this penalty if you can satisfy the CRA the over-contribution was a reasonable error, and that you withdrew the excess as soon as you could.
Hopefully, with a few myths busted, you'll take a look at TFSAs as an investment option. Depending on what you want to save towards, the miracle of compounded interest could turn it into a substantial nest egg -- all tax free.