TFSA Pros and Cons

By
10 Minutes Read

Everything you should know about this financial friend with (tax) benefits.

You probably hear the advice to open a Tax-Free Savings Account (TFSA) all the time, and it sounds too good to be true. What's the catch? And – rewind – what even is a TFSA exactly?

Tax-Free Savings Accounts are registered accounts available to Canadian residents over the age of 18, who have a valid social insurance number. You can open a TFSA at nearly any Canadian financial institution, and it’s pretty much exactly what it sounds like: a savings account that allows you to store cash – and investments – without requiring you to pay income tax when you withdraw your money. This means that dividends, capital gains and interest can grow tax free in your TFSA, saving you money (and paperwork). 

However, in order to reap the tax benefits that come along with your TFSA, you definitely need to be aware of the rules. For example, the Canadian government determines an annual contribution limit – and going over it can result in a fine (annoying, right?).

Basically, while TFSAs have a place in pretty much any financial plan, it's also a good idea to understand how this product compares to other options – like a high-interest savings account or Registered Retirement Savings Plan (RRSP), which also comes with tax advantages.

Not to fear! We'll help you sort through alllll the info out there on TFSAs by breaking things down nice and easy. Here are four reasons why it's a great idea to open a Tax-Free Savings Account (and a couple cons to be cautious of).

 

 

PRO: Your TFSA makes a great investment account

 

It's called a Tax-Free Savings Account. Where do investments come in?

You can actually hold a variety of investments in your TFSA, like mutual funds and index funds, securities listed on a stock exchange, guaranteed investment certificates, and bonds.

 

I don't have a lot of money to invest. Is that really something I should care about?

Here's the thing – investing isn't just for the rich. There are a ton of advantages to investing that simply aren't talked about enough, and a TFSA is a great way to make the most of your investment portfolio. This is exactly how it works on the Flahmingo app (and by the way, we're really into making investing accessible for everyone. You can start investing with Flahmingo for only $1 USD).

Basically, your Flahmingo investments – including stocks and exchange-traded funds (ETFs), which refers to a bundle of stocks and bonds – are all held in your TFSA account, reducing or eliminating the tax you will need to pay on your investment income.

 

 

What exactly do you mean by investment income?

There are three main ways to make money on your investments: dividends, capital gains and interest.

Dividends are payments made from a company to its shareholders, usually quarterly. They're essentially a way of redistributing company profits between all the people who invested in the company. In other words, if you invest money in a company that pays dividends, you can expect to receive payments just for holding onto the stock. Usually, it's the bigger, more established companies that choose to pay dividends to their shareholders – smaller companies that are still growing typically reinvest profits back into the company.

By having your dividends deposited into a TFSA account, you can avoid the confusing business of paying taxes on those funds. How confusing is it, you ask? Just take a look at our tax season breakdown.

Keep in mind that you may be required to pay foreign withholding taxes on U.S. dividends. We get into the nitty gritty of all that in our cons section.

Capital gains refers to the money you make for selling your shares for a profit. Let's say you buy a share for $5 and two years later, the price of that share is sitting at $10. When you sell that share, you would make a capital gain of $5. If you had to pay a broker fee of $1 to facilitate each trade (Flahmingo doesn't charge fees, btw) then your capital gain would be $4.

If you're curious, this is how taxation works for capital gains outside of your TFSA.

Just don't plan on using your tax-free account for day trading (buying and selling stocks in the same day in order to maximize capital gains). This could actually get you in trouble with the Canada Revenue Agency (CRA) because they view this kind of activity as business income.

Interest is the money paid on top of a loan, typically expressed as a percentage of the principal (the original value of the loan). While you're responsible for paying interest on, say, student debt and credit cards, in the investing world you can also earn interest.

One way to earn interest is by investing in bonds, which is a loan that you issue to a company or the government. In exchange for issuing this loan, you will often receive fixed interest payments, known as a coupon, and the eventual repayment of your money. In Canada, you are taxed on the interest you earn; however, interest gained within a TFSA is tax-free.

 

So, I should be investing instead of saving?

First of all, both saving and investing have a place in your personal finance plan; it's definitely not one or the other, so don't feel like you should convert all your savings into investments.

Your savings account is important for keeping at least some of your money liquid – meaning you can use it as an emergency fund and also have it handy for purchases you anticipate in the near future, like a spring vacation.

Holding investments in a TFSA, on the other hand, can help you grow your funds for the long-term and save money for those big milestones – like a down payment.

 

PRO: You can withdraw funds at any time, without paying taxes

 

How do TFSA withdrawals work?

You can withdraw money from your TFSA whenever you want! Just remember that if you decide to add the money you've withdrawn back into your TFSA within the same tax year, it will still count toward your contribution room (don't worry, we’ll explain how the annual limit works a little further down).

Basically, withdrawing funds from your TFSA is no big deal – and won’t involve tax payments

 

 

Isn't it obvious that I wouldn't pay taxes? It's in the name.

Well...that's actually not the case with another type of tax sheltered account: the Registered Retirement Savings Plan (RRSP). Like a TFSA, an RRSP is a personal finance tool that comes along with tax benefits.

The features of an RRSP account are meant to encourage you to grow your retirement savings during your prime working years. When you deposit money into your RRSP, those funds count as a tax deduction for that year. This tax break means you can claim your RRSP contribution on your tax return, so you won’t need to pay income tax on it. (By the way, TFSA contributions are not tax deductible. TFSA contributions are made from after-tax income – no tax break).  

However, the savings and investments held in an RRSP will not be tax free forever. If you withdraw early, you'll be required to pay what's called a withholding tax on the money held in your RRSP at the time you withdraw it. If you end up converting your RRSP to a Registered Retirement Income Fund (RRIF) – a financial product intended for retirement savings – then you will pay taxes on your RRIF payments

Now, if you do wait until retirement before accessing your RRSP funds, then you will likely face a lower tax rate on the money you withdraw than during your highest-paid working years. After all, your overall annual income will probably decrease after retirement.

Still, the bottom line is that you pay taxes when you withdraw funds from your RRSP but not from your TFSA – which brings us to our next point…

 

PRO: TFSA withdrawals won't affect government benefits

 

What do you mean by government benefits?

Income-based government benefits available in Canada include:

  • Employment Insurance (EI)
  • Guaranteed Income Supplement (GIS)
  • Old Age Security (OAS)
  • Canada Child Benefit (CCB)

Some of these benefits could require repayment if you make over a certain amount of income in a given tax year.

For example, let's say that in order to qualify for a certain government benefit, you need to make  $65,000 or less per year. Any income you earn over that amount would mean you're required to repay a portion of your government benefit.

Now let’s say that because you have investments outside of your TFSA, you end up making $64,900 in income PLUS $500 in interest and dividend payments.

In this case, you would be required to pay taxes on the interest and dividends you earned and because you’d have to claim that money as income on your tax form, the CRA could ask you to repay part of your benefits.

 

But I can withdraw money from my TFSA without tax implications?

Exactly. When you withdraw money from your TFSA account it doesn't actually count as taxable income. Therefore, you never have to worry about withdrawals from your TFSA reducing the size of your government benefits.

Now, withdrawing money from your RRSP account does count as taxable income – so these withdrawals could affect your government benefits

Looks like the TFSA comes out ahead on this front.

 

PRO: Unused contribution room carries forward indefinitely

 

Back up – what is my TFSA contribution room based on again?

Every year, the federal government sets a TFSA contribution limit – this limit has been set at $6,000 every year since 2019.

TFSA contribution room is the difference between the amount you contributed to your TFSA in a given tax year and the limit for that year. For example, if you contributed $3,500 to your TFSA in 2021, you would have $2,500 in contribution room remaining.

 

 

Now, explain how that carries forward...

This is the fun part: you can carry forward any available contribution room into the following year, beginning after 2008 (the TFSA was first introduced in 2009) or the year you turn 18, as long as you were a Canadian resident at that time.

You can find your total contribution room listed in your CRA account (because who has the time to add that all up?).

There's more – your withdrawals are actually added to your TFSA contribution room for the following year, allowing you to deposit more money into the account.

If you deposited $3,000 in 2020 and withdrew $1,000 in the same tax year, you'd have $1,000 added back to your contribution room for the following year, so in 2021. Since you only contributed half of your available contribution room (in this case, $3,000 of $6,000), the remaining amount of $3,000 would carry forward to 2021 (assuming that you didn’t carry forward contribution room from previous years).

So, in total, $4,000 would be added to your contribution room for 2021 – bringing your annual contribution limit for that year from $6,000 to $10,000. Nice!

 

Can I carry forward contribution room for RRSPs?

Yes...with a few key differences. The contribution limit for an RRSP works a little differently: you can contribute 18% of your annual income to the tax sheltered account, up to that year’s limit (in 2022, the limit is $29,210). By way, pension income can affect how much you're able to contribute to your RRSP.

So, you can carry forward unused RRSP contribution room – but it will be based on 18% of your previous year's income, maxing out, of course, at the current year's contribution limit (so don't calculate your contribution room based on your current income, if it's changed).

Also, remember how we mentioned that you can add withdrawals from your TFSA back to your contribution room for the following year? Yeah, that's not a thing for RRSPs – which means that if you withdraw funds early, you've officially lost that space in your account.

 

CON: Tax penalties for over contributing

 

How much is the tax penalty?

Ok, so you're typically charged a 1% tax per month on any amount of money held in your account that’s over the TFSA contribution limit (the “excess amount”). If that amount changes during a month (like, you’re over by $500 and you make a $200 withdrawal, so now you’re only over by $300) you’ll be taxed on the highest excess amount that was in your TFSA account that month (the $500). 

You can withdraw funds from your account to reduce that excess amount – just remember that the withdrawal will not add contribution room to your TFSA within that same tax year. The portion of the withdrawal that reduces your over contribution is called the "qualifying portion."  This means that your withdrawal will only reduce the current excess amount in your account and will not be counted against any future contributions.

 

That sounded like gibberish to me.

Me too. Here's an example:

Let's say you start with $10,000 in TFSA contribution room at the beginning of the year. You make the following contributions and withdrawals:

$5,000 contribution on June 1

$3,000 contribution on July 15

$2,500 contribution on September 1

$1,000 withdrawal on November 15

$1,000 contribution on December 15

During the months of September, October and November, there would be an excess contribution of $500 in your account (because your limit is $10,000 but you've contributed $10,500). Therefore, you'll be taxed $15 total for these months (1% x $500 x 3 months). Note that, although you made a withdrawal in November, you are still taxed on the $500, since that was the highest excess contribution in your account that month.

Now, let's get into that withdrawal. The whole 'qualifying portion' thing is a bit confusing, right? Basically, all it means is that only $500 of that $1,000 withdrawal is needed to bring the account back below the contribution limit. The CRA is pretty much okay with forgetting that you over contributed that amount and won't tax you anymore once you withdraw the excess money. However, the rest of that withdrawal won't help you if you contribute anything else to the account. Which, in our example, you do (sorry).

On December 15, you contribute $1,000 to the account. 

It doesn't matter that you took out $1,000 in November. As far as the CRA is concerned, you were back to zero dollars over the contribution limit and now you are over by $1,000. You will be taxed $10 for that month.

So, in sum, you end up being taxed $25 and you had to do a bunch of math. :(

Definitely a strike against TFSAs.

 

 

CON: You're required to pay withholding tax on U.S. dividends paid to your TFSA account

 

What's withholding tax?

In this context, we're referring to a tax applied to dividend payments from U.S. stocks, typically at a tax rate of 15%. The good news is that this money is taken off of the dividends before they reach your account – less work for you!

Keep in mind that this is a U.S. tax – like all the other funds held in your TFSA, you generally do not pay Canadian income tax on U.S. dividends.

 

 

Is this the same with RRSPs?

Well, no.

Thanks to a tax treaty between the U.S. and Canada, RRSP and RRIF accounts aren't subject to the U.S. withholding tax on dividends. Ok, RRSP…we see you.

 

In conclusion…

TFSAs are an easy way for your investments to grow tax free – and you’re not going to be hit with random fees or penalties when you decide to withdraw your money.

Although your TFSA contributions won't count as a tax deduction (ie. if you deposit your pay cheque in your TFSA account, you still pay tax on that pay cheque), the bright side is that your withdrawals don’t count as taxable income – so they won’t mess with any income-based government benefits. 

Plus, you can add your withdrawals to your contribution limit for the next year, along with any other available contribution room. 

Now, for the annoying stuff: if you go over the contribution limit, you’re punished by having to do a series of weird calculations (and with a 1% tax on your excess money). Also, U.S. dividends are subject to a withholding tax, even though you won’t have to pay Canadian taxes on your investments. 

What do you think – are you racing to your nearest financial institution to open a TFSA?

Ferron Guerreiro

Author