Home Buying Series: TFSA is More Like a Basket than an Account

A TFSA or a Tax Free Savings Account is a registered account that allows an individual over the age of 18 and a resident of Canada to put money into this account, tax free. The amount they can put is dependent on their age and how much they already have contributed into this account. Any gains made from this account are never taxed, but any losses in this account are never tax deductible either. Any amounts not contributed to this account in one year can be carried forward and contributed in future years. For my American readers, a TFSA is similar to a Roth IRA, but in my opinion, a TFSA is better, this is why.

So why do we not use the Tax Free Savings Account (TFSA) to it’s full potential? I think it is the word “account”. The word account limits the full potential of what a TFSA can be used for. When I think of account I think of chequing account and savings account, both very limiting options for your money. When I first learned about the TFSA, I pictured a basket, not an account. The “Tax Free Savings Basket” (TFSB) lol…work with me here.

Within this basket you have different types of “eggs” that represent different approaches to storing your money. Some approaches are riskier than others and provide a better rate of return long term (i.e. individual stocks, ETF, mutual funds, index funds etc.). While others are safer and provide little to no real rate of return after factoring inflation (GIC’s, savings account etc.). You decide how you want to “store” your money, but everything stored in this “basket” (TFSA) must follow the TFSA rules (I will discuss below). Here is an illustration of what I mean.

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I never said I was artistic…moving right along.

So what do you need to know about a Tax Free Savings Account/Basket, well here are the main things:

  • You must be at least 18 years old and a resident of Canada to put money in your “basket”
  • Since the TFSA’s was first introduced in 2009, if you were 18 or older at the time, you could put up to a maximum of $46,500 in 2016 in your “basket”
Year Contribution Limit
2009 $5,000
2010 $5,000
2011 $5,000
2012 $5,000
2013 $5,500
2014 $5,500
2015 $10,000
2016 $5,500
TOTAL $46,500

 

  • You can hold most types of savings and investments in this basket, including the ones illustrated above. All gains will never be taxed.
  • You can hold multiple “baskets” with different institutions and they can all have different “things” in them, as long as all the baskets (TFSA’s) put together do not exceed your total allowable contribution room in any given year (up to $46,500 in 2016).
  • Unlike the Registered Retirement Savings Plan (401k in United States), you don’t have to earn an income to earn the contribution room. You simply earn the room by being 18 or older and a resident of Canada.
  • Any unused contribution room can be carried forward indefinitely and used in future years. Didn’t contribute the full $5,500 in 2016? That’s okay, whatever you didn’t contribute gets carried over to future years.
  • Need to take out money from your TFSA? That’s cool too, any withdrawals made from a TFSA “basket” gets reset the following year. Let’s say you need to take out $10,000 from your TFSA in 2016, you won’t lose that contribution room, it will simply reset in 2017 and you can re-contribute the $10k in 2017 or onward. Be mindful of how often you contribute and withdraw money in a TFSA within the same year, too many withdrawals and contributions may cause you to go over your contribution limit and cause a penalty.
  • Any gains/dividends/interest income etc. earned in this basket are not taxable, but any losses are also not tax deductible.

 

TFSA’s are not marketed as retirement accounts by most financial institutions…but they should be. Most Canadians use the TFSA to store money for a vacation fund, emergency fund, or down payment for a home. While all of these are great savings goals, they limit the full potential of a TFSA and the benefits received from using one effectively. Even still, if you are saving money for a home, here are some benefits and drawbacks to consider when using your TFSA to do so:

Benefits of a TFSA to save for a down payment:

  • All gains earned are never taxed so you keep everything.
  • You can easily put money in and take money out of your TFSA with minimal government interference and penalties (as long as you do not exceed your room).
  • You are not required to put the money back into your TFSA once you have taken it out unlike the Home Buyers Plan from an RRSP.
  • The contribution limit can go a long way in helping you shelter 100% of your savings from taxes.

 

Drawbacks of a TFSA to save for a down payment:

  • You are using after-tax dollars when putting money into a TFSA, which means less money goes towards a down payment.
  • Since most millennials take 2-5 years to save up for a down payment for their first home (dependent on financial help from parents) whatever taxes was saved from putting money in a TFSA is minimal because with such a short time horizon only extremely safe options that offer a low rate of return are viable (i.e. GIC or a savings account)
  • With a 5 year or less time horizon, most will save their money in a TFA savings account or TFSA GICs to significantly reduce risk. This can translate into up to $46,500 per person ($93,000 for a couple) earning less than 1% a year before inflation on their savings. Yes, no taxes would be paid, but at the expense of not paying taxes on $465 ($46,500 *1%) of interest income.
  • Maxing out contribution room for a TFSA to put money in safe investments like GIC or savings accounts means not being able to use any of that room to invest in a balanced portfolio that can offer 6% rate of return long term, tax free.
  • Lost time and compound interest. You may decide to use the TFSA for a down payment and then to save for retirement once you’ve bought a home. Since you don’t lose your contribution room, this is an option. However, like with any long term investment, time and compound interest can have a major impact on your retirement nest egg. The time lost from having your balanced portfolio grow in a TFSA cannot be brought back.

 

So where to save for a down payment?

  • A basic savings account. Most financial institutions offer negligible interest rates to store money in a basic savings account (anywhere from 0.1% to 0.8%). Yes, you would have to pay taxes on the interest earned, but at such low interest rates, the tax hit would be minor and you can use the TFSA room for long term investments that give you a higher rate of return. Don’t forget there are tax deductions that you may be eligible for as well that could offset any taxes.
  • A chequing account with a separate bank. Open a chequing account with a financial institution you do not frequently bank with. Many chequing accounts do not offer interest for storing your money, and if they do, they are usually more negligible than savings accounts. Be sure to choose institutions that waive your monthly charges if your minimum balance is above a certain amount. Since you are not going to use this account for daily spending, get the cheapest monthly plan possible and store more than the minimum balance needed to waive monthly fees.
  • If want to incorporate the TFSA, consider a 50/50 split and put half of contributions towards a down payment in a TFSA and the other half to a basic savings account or RRSP. This way, you will have some TFSA room to contribute towards a balanced portfolio that offers a higher rate of return and you will be able to withdraw this money tax free in the future.

 

We currently use 100% of our TFSA room for long term investments including: US, Canadian, International index funds, a few individual stocks that pay a great dividend, mutual funds, DRIPS etc. Our emergency and planned spending funds (totaling $15,000) are in non-registered accounts. This means we pay taxes on the interest, but with the negligible interest rates financial institutions are offering (and other tax deductions we can use to offset this income), we decided to opt for this option.

 

Categories: Investing, Life, Savings

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2 replies

  1. Thanks for sharing this post. I use my TFSA for individual dividend paying stocks 🙂

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