An estimated 62 percent of Canadian adults have a tax-free savings account (TFSA) with an average balance of $41,510 in 2023, according to a recent BMO report.
The success of the TFSA since its launch in 2009 is due to its simplicity: you can invest in virtually anything traded on the major global exchanges, and if you’re successful, you don’t have to pay taxes on the gains.
A TFSA is different from other investment accounts because capital gains from stock investments, as well as income from dividends or fixed income securities, are not taxed…at least in most cases.
The belief that all investment gains are tax-free is one of six common TFSA myths that can lead to missed tax savings or, worse, financial penalties from the Canada Revenue Agency (CRA).
1. Investment gains are never taxed
The “tax-free” half of the TFSA is misleading.
U.S. dividends generated in a TFSA are subject to a 15 percent withholding tax from the Internal Revenue Service (IRS). This is collected directly by the U.S. government and cannot be reclaimed through foreign tax credits within a TFSA.
This includes dividend payments in US dollars from generous and reliable global companies that make up the 97 percent of the world’s publicly traded stocks that are not Canadian.
This includes foreign mutual funds or exchange-traded funds (ETFs) and even Canadian mutual funds and ETFs that hold foreign stocks.
2. TFSAs are savings accounts
Even the “savings account” part of TFSA is misleading.
Since only investment gains are tax-free, there is no point in treating your TFSA like a traditional savings account – which typically yields negative returns after fees.
Even with “high-interest savings accounts,” the returns are poor for small amounts and are well below two percent for large balances.
TFSA contributions must be invested to benefit from tax savings. This could include guaranteed investment certificates (GICs), which currently yield about five percent annually and would otherwise be fully taxed in a non-registered account.
Tax-efficient TFSA investments also include securities such as stocks, mutual funds and exchange-traded funds (ETFs), where half of the capital gains would be taxed in a non-registered account.
3. Contributions are tax deductible
Many Canadians confuse the TFSA with the Registered Retirement Savings Plan (RRSP), where contributions can be deducted from taxable income.
Income from TFSA investments is generally tax-free, but contributions are not.
4. You can contribute again at any time
Unlike the RRSP, withdrawals from the TFSA can be made at any time without tax consequences.
In addition, unlike the RRSP, the permissible contribution margin is fully restored upon a TFSA withdrawal.
However, if you contribute the maximum amount, a TFSA’s contribution margin will not be restored until the following calendar year.
5. The bank informs you when you have reached the maximum
Many Canadians contribute to their TFSA through more than one institution, and it is the account holder’s responsibility to ensure they do not exceed the limit. Overpayments can result in fines.
The CRA tracks TFSA limits for individuals on their annual tax returns and CRA online accounts, but they typically reflect the previous year, so be sure to include contributions made in the current year.
The total contribution limit for TFSA deposits increased by $7,000 for everyone over 18, effective Jan. 1. The accumulated contribution margin varies for individuals depending on the deposits and withdrawals made over the years.
To give you an idea of what this might mean, the total allowable amount for people aged 18 and over is currently $95,000 since its introduction.
6. TFSAs are intended for short-term goals
The TFSA is generally viewed as a short-term savings vehicle to fund things like a new car, a pool, or that big vacation. That’s true, but given the increased contribution limit, it can also be a tax-efficient retirement savings vehicle when used in conjunction with an RRSP.
RRSP contributions and any gains they generate as investments are fully taxed when withdrawn. If these investments grow too much, retirees could be forced to take withdrawals in a higher tax bracket and even face retirement savings (OAS) clawbacks.
By strategically allocating your retirement savings between an RRSP and a TFSA, you can limit future RRSP withdrawals to the lowest tax bracket and supplement the necessary funds through tax-free TFSA withdrawals.
