How the TFSA Changed the World (…of investing…in Canada)
Before the Tax-Free Savings Account (TFSA), we had two options when investing money in Canada:
- Non-Registered investments: You invest with your after-tax money, you pay tax on interest or dividends earned every year, and when you sell them you have to pay capital gains tax on any investment growth you didn’t already pay tax on over the years.
- Registered Retirement Savings Plan (RRSP) investments: You invest with tax-free money, you pay no tax on interest or dividends earned every year, and when you are 71(or earlier) you convert to a Registered Retirement Income Fund(RRIF) account and only pay taxes on whatever you are required to withdraw, based on your age.
The idea was that you max out your RRSP contribution room first, with investments that generate income that is taxed at a higher rate, like interest income and dividends. You want these types of investments because the RRSP shelters them from tax and they grow tax-free.
Then if you have money left over after you max out your RRSP limit, you put it in a regular investment account or bank account. Maybe you buy stocks for 40 years and then you sell them off as you retire.
No matter how you split these two things up, you are still paying tax in retirement.
RRSP investments turns into RRIF investments at 71 and you have to take out a specific amount and pay the tax on that amount. You don’t have to worry about tax on growth, or capital gains or anything like that, just whatever you withdraw, and you are forced to withdraw more and more as you get older.
Non-registered capital gains are taxed at 50% of your tax rate, so if you sell stocks to get $50,000 you only pay tax on $25,000, which isn’t so bad, compared to having to pay 100% taxes on interest income from your savings account.
CAPITAL GAINS: this is when you sell a stock in the future for more than you bought it for. The stock sits there and grows and you don’t have to worry about it until you are older. Then you pay 50% tax on the difference between what you paid for it and what you got when you sold it.
WHAT EXACTLY IS A TFSA ANYWAY?
The Tax-Free Savings Account(TFSA) is not a savings account at all.
It probably has the worst name for what it actually is.
The TFSA is a government savings plan, just like the RRSP. See my post on the RRSP for details.
A TFSA is just government rules that are applied to your investments.
The types of investments you can hold in a TFSA type account are the same as an RRSP type account.
For example, you can go to the Tangerine site and buy their index funds. Depending on your available contribution room under the TFSA or RRSP, you can tell Tangerine to designate your index fund investment as either TFSA or RRSP.
All Tangerine is doing when you tell them this, is checking a box on a form they have to submit to the government. And when they check either the TFSA or RRSP box, the government is told that you have X amount of dollars invested in something(an index fund, in this case) and either you want it to count against your TFSA or your RRSP room.
(To check your available contribution room for both, go to the CRA website and sign up for something called MyAccount. You’ll thank me later when you need this information in a pinch.)
It’s up to you to keep track of what types of accounts you open, because the investment companies don’t know your overall limits and don’t track all of your investments.
But don’t worry…the government will tell you if you have exceeded your room under each plan… and you’ll pay penalties for it!
So be careful and always make sure you have available room in either plan, before telling someone to check either box.
HOW THE TAX-FREE SAVINGS ACCOUNT (TFSA) CHANGED EVERYTHING
So the lesson we learned before the TFSA was introduced is that you are going to pay taxes when you retire.
It can’t be avoided completely, just delayed.
Whatever combo of RRSP and non-registered withdrawals you take, you will eventually pay tax on both withdrawals.
But when you take money out of a TFSA, you pay nothing.
TFSA: You invest with your after-tax money, you pay NO tax on interest or dividends earned every year, and when you sell any investments you have NO capital gains tax on any investment growth.
This is why it’s called tax-free. Other than the income taxes you paid when you earned the money, there are no more taxes to worry about.
Most people compare TFSAs and RRSPs using one common concept: TFSAs don’t get a tax refund, and RRSPs do.
And then you take your RRSP tax refund, and invest that too, right? Right???
The truth is, if you do invest your tax refund you are among the minority.
This article by David Chilton tells me that most Canadians buy all investments with after-tax dollars and then if they get an RRSP refund…they spend the money.
So let’s face reality and compare our investment options by starting with after-tax money that is sitting in your regular bank account:
|Value after 30 years @ 4%||$500,000||$500,000||$400,000|
|In retirement you start taking the 4% as income||$20,000||$20,000||$16,000|
|Less the tax on withdrawal at retirement(30%)||$0||$6,000||$4,800|
*Numbers are rounded and are not exact – it’s just an example to show you the approximate difference
Since we are investing with after-tax money, the TFSA and RRSP grow to the same amount after 30 years.
But the non-registered amount is $100,000 lower because you had to pay taxes on the growth every year, and you paid those taxes from your investment balance (to keep the example very simple, I assumed your investment income was bank interest income and taxed as you made it every year).
Now unfortunately, you can only put $5,500/year in a TFSA going forward, but if you haven’t started yet, you can catch up and put up to $52,000 in a TFSA using the contribution room you earned from 2009 to 2017. They say it will go up by $500 every year or so for the next little while, but for now let’s assume $5,500/year is fixed for the sake of simplicity.
If you are 35 and transfer $52,000 into a TFSA account now, and then contribute $5,500 every year until you are 65, at 4% annual growth, you will have around $500,000. (Inflation is ignored for this example because it complicates everything. Just assume everything will cost the same in 2048, ok?)
Maybe you’re thinking $500,000 isn’t a lot of money to draw from in retirement, but when you turn 65 you get CPP and OAS too and that could be $20,000/year to start with (in 2048, maybe, if we’re lucky).
Personally, I only need around $35,000 to $40,000 a year in after tax income to live a decent life so I used $40,000 as my desired retirement income at the age of 65.
That means I only need another $20,000/year from my investments!
Guess what, 4% of $500,000 is $20,000.
So not only is $500,000 enough to retire on(for me, in this example), but if it’s invested in something that generates a 4% return when I retire, I can live on that return FOREVER.
Maybe some years it will get more than 4% and I’ll bank the difference to make up for other years when it’s less than 4%.
Investments make $20,000: I spend it and then it magically comes back the next year.
Government gives me $20,000: I spend it and then it magically comes back the next year.
I don’t have to do anything.
It just happens.
Until the day I die…
BUT WHAT IF I NEED THE MONEY INSIDE MY TFSA AFTER I PUT IT THERE AND I CAN’T WAIT 30 YEARS FOR IT TO GROW TAX-FREE?
This is the good(and bad) thing about TFSAs. You can move money in and out of them without penalty. The only restriction is that you can’t contribute more than the maximum in one year. So, for example:
If you deposit $5,500 into a TFSA savings account and then halfway through the year, you remember that you actually need it to buy stuff, you can take it out without penalty.
HOWEVER, now you can’t make any more contributions this year.
You get the $5,500 back…but only NEXT YEAR. So overall you keep the same contribution room, there’s just a delay before you can use it again.
If you went ahead and deposited another $5,500 and you didn’t have room from prior years, you would be taxed 1% per month until you withdrew that amount from your TFSA.
So be careful with the TFSA, and if you are careful and wise, you can have 30 years of tax-free growth and then take out the money tax-free when you retire.