Understanding TFSAs:

The 8 Benefits
(And 3 Drawbacks)
of TFSAs

Owen Winkelmolen

Fee-for-service financial planner and founder of PlanEasy.ca

Tax-Free Savings Accounts (TFSAs) are relatively new. They were introduced in just 2009. Even though they’ve only been around for a short time they’re already the most used out of the major tax-sheltered accounts. There are over 5.5 million households in Canada that have an active TFSA account.

(Authors Note: I love it when people use their tax-sheltered accounts. Good tax planning is a key component of any financial plan and can add $100,000’s to your net worth)

The average usage rate for the TFSA is pretty impressive at 40.4%. This is relatively consistent across both age and income. The highest usage rate is in Ontario where over 45% of the households are using a TFSA. The median contribution to a TFSA in 2016 was $5,765.

All-in-all these are impressive numbers for a new tax-sheltered account.

Given the high usage rate the TFSA must be pretty great, right?!?!

In this post we’ll cover exactly how a TFSAs works, the benefits of a TFSA, as well as some of the drawbacks of a TFSA.

Understanding TFSAs: How They Work

TFSAs are as simple as it gets. Contributions are made post-tax and they grow tax-free. They help you avoid tax on your investment growth.

The TFSA contribution limit is $5,500/year for each person over the age of 18. Unused contribution room carries forward. To check your contribution room sign into the CRA online portal or request a TFSA Room Statement from the CRA. There is no TFSA lifetime limit, your contribution room continues to grow every year!

TFSAs provide the biggest benefit when you put ‘high growth’ investments inside of your TFSA. Don’t be fooled by the name “Tax Free Savings Account” you can put almost any investment inside a TFSA. This includes stocks and bonds.

Think of a TFSA like a magic box where taxes don’t apply. Put any investment inside your TFSA and magically investment gains become tax free.

Withdrawals from a TFSA can be made at any time. Whatever you withdraw will get added to your contribution room the following year.

All this makes TFSAs great for retirement planning. It forms the cornerstone of the simple retirement plan.

There are lots of benefits with TFSAs but also some drawbacks too.

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Benefits:

Tax-Free Compounding:

Investments inside a TFSA grow tax-free. This lets your investment compound faster without the drag of annual taxes. How much is this tax-free compounding worth? Potentially $100,000’s.

Someone who contributes about $3,500 to their TFSA each year for 40 years will have an additional $358,963 in tax-free growth!

Check out the two charts below for more details.

 

No Barrier To Withdrawals:

TFSA withdrawals can be made at any time and without any withholding tax.

 

Share Contribution Room With A Spouse:

Because TFSA contributions are made with post-tax dollars the government doesn’t care if you make contributions to your spouse’s TFSA. This means you can share contribution room with your spouse and maximize their tax-sheltered space too. (You cannot do this with an RRSP, unless you want to get audited that is)

 

Contribution Room Is The Same, Regardless Of Income:

Regardless of your income, the contribution room for a TFSA is the same. This is great for low and moderate income earners. For these households it’s possible to tax-shelter a higher % of their income. The average Canadian family can shelter 32% of their income in tax sheltered accounts. Thanks to the TFSA, this increases for low income earners.

 

Contribution Room Returns The Next Year:

When you make a withdrawal from your TFSA the contribution room will come back the following year on Jan 1st. This means you can use a TFSA to save for short/medium term goals like a down payment or a wedding.

 

No Mandatory Withdrawals:

There are no mandatory withdrawals with a TFSA. You can let a TFSA grow tax-free for your entire lifetime. RRSPs have forced withdrawal rates after age 71.

 

Withdrawals Won’t Impact Government Benefits:

Making a withdrawal from a TFSA won’t count as income. This means there is no impact on government benefits.

This is especially helpful for low-income seniors who receive benefits with high claw back rates, sometimes as high as 50%-75% of the next dollar earned.

 

No Tax Upon Death:

Because TFSAs are tax-free there is no tax upon death. This means you can transfer your assets to your children without any impact from taxes.

 

Related Posts:

 

TFSA

Annual $3,517 Post-Tax Contribution

$865,006 Cumulative Withdrawals (After-Tax)

Taxable

Annual $3,517 Post-Tax Contribution

$506,043 Cumulative Withdrawals (After-Tax)

Drawbacks:

No Barrier To Withdrawals:

Although this is a benefit I believe it is also a HUGE drawback of TFSAs. Retirement savings inside a TFSA are more likely to be “raided” because TFSA withdrawals can be made at any time and without any withholding tax.

 

No Income-Tax Reduction:

Unfortunately, TFSA contributions can’t be used to lower your taxable income. This means there is no way to decrease your income tax when contributing to a TFSA. For high income earners this makes an RRSP more appealing.

 

No Protection From Creditors:

Another big drawback is that TFSAs aren’t protected from creditors. If you’re involved in a law suit or bankruptcy your TFSA can be confiscated by your creditors. If you use a TFSA for your retirement savings they could unfortunately take it all.

RRSPs on the other-hand are protected from creditors.

You can protect yourself from this possibility with strong vehicle/property insurance and also umbrella insurance. Still, this is a risk with using TFSAs as your main retirement account.

Owen Winkelmolen

Financial planner, personal finance geek and founder of PlanEasy.

New blog posts weekly!

Tax planning, benefit optimization, budgeting, family planning, retirement planning and more...

New blog posts weekly!

Tax planning, benefit optimization, budgeting, family planning, retirement planning and more...

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