If you are the average Canadian, you spend roughly three months working to pay taxes before you pay yourself a dime. This is based on an average income tax rate of 23.2% in 2020 1 .
But there is good news. There are legal ways to reduce and avoid taxation. One way is through investing. Tax rates on investment income are lower than rates on your regular employment income.
And it gets better. Income generated from investments in the Tax-Free Savings Account (TFSA) is tax-free.
My goal is to have you leave this post with a better understanding of the TFSA, as it’s often not taught by anyone else.
Don’t worry if you feel like you don’t know enough. That’s very normal. You are in the right place and have the capacity to understand and use the TFSA to your benefit.
Table of Contents
The Tax-Free Savings Account (TFSA) has a singular benefit. It shelters you from taxes on income produced by the investments located inside the account. There are three primary types of investment income:
- Interest Income;
- Dividend Income; and
- Capital Gains Income.
To understand the benefits of the TFSA, you first need to understand the basics of how taxes apply to investment income. First, we have to look at how investment income is taxed in a normal investment account.
Such a “normal” investment account is called a non-registered account, or a taxable account. In a taxable account, different types of investment income are taxed in different ways. Let’s have a look at the primary types of investment income:
- Interest Income from bonds, GICs or a savings account is taxed at the same rate as your regular employment income, at your marginal rate.
- Capital Gains Income from the increase in the price of an investment asset is taxed at 50% of your marginal tax rate.
- Canadian Eligible Dividends are taxed at low rates relative to regular income.
- Foreign dividends are taxed at your marginal tax rate, just like employment income and interest income.
The only exception is withholding tax for income from foreign dividends and interest. I’ll talk about this below.
Tax Free "Savings" Account: A Misleading Name
I have beef with the name Tax-Free “Savings” Account. It is misleading.
The TFSA provides zero value unless income is produced within the account. For the TFSA to have utility, you must generate investment income.
This can be interest income, capital gains income or dividend income.
That’s good when it makes sense for you to hold cash, like when you need the money in less than 5 years. But it is not good if Canadians are holding cash in the TFSA because the name has convinced people that it is a savings account.
I wish it was called the Tax-Free Investment Account instead.
What Investments Can I Hold In the TFSA ?
Various types investments can be held in your TFSA. You can use a self-directed TFSA, where you buy and sell your own investments from within the account. According to the CRA, you can hold the following types of investments:
- Mutual Funds;
- Guaranteed Investment Certificates (GICs); and
- Securities listed on a designated stock exchange.
Securities listed on a designated stock exchange include:
- Individual stocks;
- Exchange-Traded Funds; and
- Real Estate Investment Trusts.
As an example, I use RBC Direct Investing. I transfer money from my chequing account to my TFSA. Once the cash is in the TFSA, I use it to buy Exchange Traded Funds (ETFs) to invest in an index of my choice.
TFSA Contribution Room: How It Works
Unlike the RRSP, you contribute after-tax income to the TFSA. You can contribute by transferring money from a chequing or savings account to the self-directed TFSA. The exact mechanics will depend on your bank.
The limiting factor of the TFSA is the amount you can contribute. Your contribution room begins accumulating from 2009 or the year you turned 18, whichever is later. Let’s go through more exciting contribution room details.
Every year the CRA outlines an annual TFSA “dollar limit”. All annual limits since the TFSA started in 2009 are outlined in this table. I acquired this data from the CRA’s site – straight from the horse’s mouth.
Your total TFSA contribution room is the sum of all “annual dollar limits” since the year that you turned 18.
What if I Did Not Use Contribution Room From Prior Years?
Unused contribution room carries over and accumulates. For example, if you’ve never contributed a dime to the TFSA, you can still contribute $75,500 today, as long as you were 18 in the year 2009. This applies even if you have never opened a TFSA.
The only thing you lose out on by not contributing right away is the tax-free investment growth you could have achieved. Time is your best friend when it comes to growing wealth.
But don’t beat yourself up. The best time to start investing is now, and you’re on the right path. You’re actively reading to enhance your personal finance competence.
Where To Find Your Contribution Room
Your CRA My Account
Your CRA MyAccount will tell you your contribution room as of 01 January this year. Therefore, your CRA MyAccount will not capture changes made within the current calendar year. I’ve snipped the CRA My Account below on 24 Oct 2021. As you can see, the TFSA and RRSP room is updated as of 01 Jan.
TFSA Contribution Room Calculator
I built this TFSA contribution room spreadsheet to help myself:
- Track TFSA contribution room during the current year;
- Estimate future TFSA account value; and
- Estimate future tax-free cash flow generated by investments within the TFSA.
You can download the excel copy or save it to google sheets. It will help you wrap your head around how the contribution room works.
Contribution Room Example
Jake turned 18 in September 2010 (born in 1992). He did not receive the $5,000 of contribution room in 2009 because did not turn 18 until 2010.
Therefore, Jake’s total contribution room in 2021 is the sum of the annual limits from 2010 to 2021 equating to $70,500.
How Do TFSA Withdrawals Affect Contribution Room?
TFSA withdrawals in this calendar year will increase your contribution room in the next calendar year by an amount equal to the withdrawal. This sounds like legalize. I will use an example.
Example: TFSA Withdrawal and Contribution Room
Jill maxed her TFSA in 2020 – she reached her total contribution limit and has zero contribution room remaining.
In 2020 Jill withdraws $10,000 from her TFSA to purchase a car. The $10,000 withdrawal generates $10,000 of contribution room in 2021 in addition to the annual contribution limit for 2021 of $6,000.
Therefore Jill will be able to contribute $16,000 to the TFSA in 2021. Jill cannot contribute any more to the TFSA in 2020 even after she made the $10,000 withdrawal – she must wait until the 2021 calendar year.
Watch Out for Commissions
I pay commission fees of $10/trade with credit card points. Each transaction counts as a $10 contribution to my TFSA.
You can save valuable contribution room by searching for a low commission broker, or by limiting trading frequency.
I have low trading frequency, with less than 10 trades per year as I Dollar Cost Average with Index Funds. Plus, RBC Direct Investing has many features that I like. Therefore, I haven’t changed banks. I pay the fee.
Plus, higher trading frequencies are indicative of over-confidence and are proven to reduce returns.
What Happens If I Over-Contribute to the TFSA?
Any overages in excess of your total contribution room will be taxed at 1% of the highest overage per month. Nobody wants to pay preventable fees, especially frugal investors.
You must keep very close tabs on your contribution room when you are:
- Nearing your total contribution limit; and
- You are making withdrawals and contributions in the same year.
I use my CRA My Account to keep track of TFSA Room at the beginning of each year. You can then carefully monitor annual contributions counting down from this amount, and provide a buffer of at least a few hundred dollars.
Don’t over contribute! Tracking your TFSA contributions is your responsibility.
The TFSA and Taxes
The TFSA Is More Valuable as Income Increases
Tax rates for dividend, capital gains and interest income increase as you earn more. The more you earn, the more it pays to learn – about taxes.
Therefore, the TFSA provides more tax-sheltering benefits for high earners. However, the RRSP also becomes more valuable relative to the TFSA as your income rises.
Foreign Withholding Tax
There is one type of tax that you can’t avoid in the TFSA, and that’s foreign withholding taxes.
Nearly all countries have a withholding tax of some form. The U.S. withholding tax is the most important for Canadian investors. The U.S government “withholds” 15% of dividends paid by U.S. companies to Canadian investors and 10% of interest income.
And you don’t get away from withholding taxes if you hold a Canadian-listed ETF that directly holds U.S. stocks like Vanguard’s S&P500 ETF VFV. The only way to bypass withholding taxes is by holding a U.S. listed security in the RRSP.
So don’t be surprised when you only receive 85% of your expected US dividend amount – 15% was automatically withheld. For Canadian listed ETFs that hold U.S. stocks, the distribution yield of this ETF already accounts for withholding taxes.
How Do I Make The Most of my TFSA?
Everyone’s goals are different, so for this portion, I’ll share my personal approach.
I make the most out of my TFSA by reaching the contribution limit as soon as possible. Once the money is transferred to the TFSA, I invest in low-cost globally diverse equity (stock) index ETFs.
Investing ASAP maximizes my time in the market, so I can extract the most from compound growth. Further, I prioritize equities (stock) in the TFSA due to the higher expected returns relative to bonds.
But I only invest in stocks because I have the ability and willingness to take on risk. You can read more about these factors in this post.
Before investing, it is important that you understand your unique risk tolerance. Once you are comfortable with your risk tolerance, you can determine an asset allocation that works for you. This Vanguard Investor Questionnaire can help you with this process.
Investment Growth: The Key to A Large TFSA
As your investments snowball under compound growth, you will have a large dollar value in the TFSA that far exceeds your total contribution room. The money in the TFSA can then be used to generate tax-free income in the future.
TFSA Growth Example 1
Sam has contributed the maximum to her TFSA each year since 2009. Upon contribution to the TFSA, Sam immediately invested her money in a S&P500 index fund. In 2021, Sam’s TFSA account value is $200,000. Her total contribution was $74,500.
Sam read the trinity study and understands safe withdrawal rates. So she decides to pull 3% of the TFSA value, or $6,000 of tax-free income, every year. Sam understands that her investments in the TFSA can sustainably generate 3% annually, accounting for inflation, while maintaining the TFSA value.
TFSA Growth Example 2
Sarah turned 18 in 2009 and has reached her total contribution limit of $69,500 in 2020. Sarah continues to contribute the maximum each year, and earns a 10% compounded annual rate of return on her investments.
By 2033, 42 year old Sarah has a TFSA principle value of $639,000 and has contributed a total of $157,500. At a reasonable 4% withdrawal rate, Sarah can pull $25,500 per year as tax free investment income.
Sarah now has flexibility to do what she wants. Sarah makes money in her sleep. Be like Sarah.
How To Become a TFSA Millionaire
It’s reasonable to reach a Tax-Free Savings Account (TFSA) account value of $1,000,000 dollars or more in the next 30 years. Then you are a TFSA millionaire.
This assumes you contribute the maximum each year and achieve the historical returns of global equities (stocks) of 8% per year (source).
As a TFSA millionaire, you could pull over $30,000 of tax-free income from the TFSA assuming a safe withdrawal rate of 3%. And you could sustain that withdrawal rate for over 30 years according to the Trinity Study. Not bad.
The TFSA Calculator will crunch the numbers for you to determine your future TFSA account value.
What If I Lose Money in my TFSA?
You cannot use tax-loss harvesting if you lose money in your TFSA. The losses are gone, with no changes to your contribution room.
This, combined with the precious contribution room, is the reason why I value wealth preservation over high returns.
I’ve lost money speculating with options in the TFSA. That means I lost valuable contribution room. Losses are the tuition you pay sometimes while learning how to invest. Tolerance for such losses is one of the benefits of investing while young.
- Investment income from dividends, capital gains or interest is tax-free in the TFSA.
- There is a limit to the total amount you can contribute to the TFSA. Use the contribution room calculator to figure out your contribution room. Unused contribution room accumulates throughout the years.
- Growth in TFSA account value does not change your contribution room. Losses in the TFSA do not free up new room and cannot be written off for tax purposes.
- Stocks, Bonds, Exchange Trade Funds (ETFs), Real Estate Investment Trusts (REITs), a nd Guaranteed Investment Certificates (GICs) can be traded within the TFSA.
- My strategy is to reach the contribution limit as quickly as possible and let compounded growth of equity (stock) index funds grow my TFSA value. I will then pull tax-free dividend/interest income later in life.