A Tax-Free Savings Account is completely tax-free? False.
A Tax-Free Savings Account is generally tax-free, however, there are implications surrounding withholding taxes on certain foreign investments.
A Tax-Free Savings Account is an investment account registered with the Government of Canada. According to a 2018Ipsos poll, the majority of Canadians have a TFSA.
Free savings account (TFSA), Canadian finance student
According to the same poll, nearly half of Canadians believe that a TFSA is good for saving money but not growing it. This could not be further from the truth. If you invested in the TSX Composite Index back when the TFSA was first introduced in 2009, by late last year, your investment would have doubled and none of this growth would be subject to tax. Today in this post, we’re going to be talking about the Tax-Free Savings Account, better known as the TFSA.
A Tax-Free Savings Account is a savings account? False.
In the midst of the 2008-09subprime mortgage crisis, better known as the previous financial crisis, the Canadian government introduced the TFSA as a means to encourage Canadians to grow their wealth.
Effective January 1st, 2009, Canadians earn investment income in the TFSA free of Canadian taxes. By investment income, I am referring to interest income, dividend income, capital gains, as well as other sources of income derived from the investments held within a TFSA. Often times, Canadians misunderstand the characteristics of a TFSA.
So, I will do my best to break these down for you. First of all, a TFSA is not an investment product. It is rather an investment account. An investment product is what you are investing in such as stocks, bonds, or funds. An investment account is where you decide to hold your investment products.
An investment account may be registered or non-registered. A registered account is simply an account registered with the Government of Canada to receive some sort of unfavorable tax treatment. These may include TFSAs, RRSPs, RRIFs, RESPs, as well as RDSPs. Essentially, you could think of an investment account as a vehicle and the investment products it holds, as passengers.
The TFSA may hold qualified investment products such as stocks, bonds, ETFs or exchange-traded funds, mutual funds, savings deposits, or term deposits. To open a TFSA, you must be at least 18 years of age and have a social insurance number.
To contribute to a TFSA, you must be the age of majority in your province, have a social insurance number, and be a resident of Canada. Now, I know that the age of majority may differ by province between 18 or 19. Here in Ontario, it is 18. But I know for some provinces, including British Columbia, it is 19. As a non-resident with a social insurance number, you are not able to make any TFSA contributions until you are a resident of Canada. However, as a non-resident, you could keep your TFSA open for the previous contributions made.
Contributions made as a non-resident will be subject to a penalty of 1% per month until the earlier of two dates: the date on which you become resident of Canada and the date on which the excess contributions are withdrawn.
Now that we know what TFSA is, let us zoom in the details. Every year, the Government of Canada sets annual contributions limits which accumulate from one year to the next in determining your total contribution room. In other words, the amount of money you could invest in a TFSA is limited to your total contribution room. Investment income earned tax-free allows your investments to grow stronger and faster as you are able to retain 100% of your investment income.
However, keep in mind that these forgiven taxes are revenues foregone by the government and not to mention, the potential displacement effect TFSAs have on other registered accounts such as RRSPs. So essentially, our TFSA contributions are limited.
The formula to calculate your contribution room is quite simple. Your contribution room for 2020 is equal to your total annual limits to date minus your contributions plus your withdrawals up to an including last year. So here are the annual contribution (limits) the Government of Canada has set out by year. Now, let us look at an example.
Let us say you were born in 1991 or earlier, and you have never made any TFSA contributions before. Your total contribution room for 2020 would be $69,500. In another example, if you are born in 1999, and you have never made any TFSA contributions before, your total contribution room for 2020 would be $23,000.
If you were born in 1999 and you contributed$5,000 in 2017, and then you withdrew $2,000 in 2018, and then you withdrew $1,000 in 2019, your 2020 contribution room would be $21,000.
So, what happens if you over-contribute? Well, there will be penalties. You will be penalized at 1% per month in the tax of the excess contribution until that excess contribution is withdrawn. One of the most appealing characteristics of the TFSA is the ability to make tax-free withdrawals, which is not the case for other registered accounts.
Another great perk of the TFSA is the ability to re-contribute withdrawals back into your TFSA on or after January 1st of the following year. Now keeping mind that I say January 1st of the following year.
Now, let us say you withdrew $1,000 from your TFSA on September 1st,2020. This will not impact your 2020 contribution room. Instead, your contribution room will increase by $1,000 on January 1st,2021 in addition to the annual limit set out by the Government of Canada for that year.
Re-contributions of TFSA withdrawals are a great way to grow your TFSA portfolio, unlike RRSP accounts where withdrawals result in permanently lost contribution room. However, RRSPs have other great tax benefits that TFSAs do not offer such as exemptions from U.S. withholding taxes as well as a tax deduction upon contribution.
I plan on covering the RRSP account in detail some time in a future post. One final but important consideration of the TFSA is the implication of withholding taxes. Now, TFSAs are certainly exempt from Canadian taxes.
However, if you hold foreign investments within your TFSA, these foreign investments may be subject to foreign withholding taxes. I do not promote the following investment but let us say, for example, you have a U.S. stock in your portfolio. Let us say Microsoft.
Microsoft happens to have a 1% dividend yield. At the end of one year, you will have earned a dividend income of $10. Now, if Microsoft was a Canadian stock, there would be no tax implications and you would keep the entire $10 dividend.
But since Microsoft is a U.S. stock, you would be subject to 15% in U.S. withholding taxes which means instead of receiving $10, you will only receive $8.50 after a $1.50 in withholding taxes.
While it is important to consider withholding taxes, it is also important to note that foreign markets offer lucrative investment opportunities with the potential for diversification which should not be overlooked simply due to withholding taxes. On a side note, U.S. listed U.S. stocks may be held in an RRSP to be exempt from U.S. withholding taxes.
Savings Account (TFSA)
Now prior to wrapping up this post, let us recap the characteristics of a TFSA. The TFSA is an investment account registered with the Government of Canada that shields investment income such as interest income, capital gains, dividend income, as well as other sources of income from tax.
The TFSA may hold qualified investment products such as stocks, bonds, ETFs, mutual funds, savings deposits, as well as term deposits. To open a TFSA, you must be at least 18 years of age and have a social insurance number.
To contribute to a TFSA, you must be the age of the majority of your province, have a social insurance number, and be a resident of Canada. As a non-resident, you are not allowed to make any TFSA contributions until you are a resident of Canada. As a non-resident, however, you could keep your TFSA open for the previous contributions made.
Your total contribution room is equal to the annual limits set out by the Government of Canada minus the contributions you have made plus the withdrawals you have made up to and including last year.
Over-contributions to a TFSA are subject to a penalty of 1% per month until these over-contributions are withdrawn. And finally, withholding taxes. The withholding tax rate on U.S. dividends and interest income is 15% and this rate may differ from country to country.
Nonetheless, investors should not be deterred from seeking growth, income, or diversification opportunities in foreign markets simply due to withholding taxes.
In essence, the TFSA is a great account to save up for future cash needs whether that be for a down payment on a home, retirement, purchase of a car, pursuing further education, building an emergency fund, or simply building net worth.
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