An estimated 62 per cent of Canadian adults have a tax-free savings account (TFSA) with balances that averaged $41,510 in 2023, according to a recent BMO report.
The success of the TFSA since its launch in 2009 is rooted in its simplicity; you can invest in just about anything that trades on major global exchanges. If you are successful, you walk away without paying tax on the gains.
A TFSA is different from other investment accounts because capital gains on equity investments, and income from dividends or fixed income are not taxed…well, in most cases.
The belief that all investment gains are tax-free is one of six common TFSA myths that could result in missed tax savings or worse; financial penalties from the Canada Revenue Agency (CRA).
1. Investment gains are never taxed
The “tax-free” half of TFSA is misleading.
U.S. dividends generated in a TFSA are subject to a 15 per cent withholding tax on behalf of the Internal Revenue Service (IRS). It is applied directly by the U.S. government and can not be reclaimed through foreign tax credits within a TFSA.
That includes U.S. dollar dividend payouts from the generous and reliable global companies that are part of the 97 per cent of publicly traded global equities that are not Canadian.
It also includes foreign mutual funds or exchange-traded funds (ETFs), and even Canadian mutual funds and ETFs that hold foreign equities.
2. TFSAs are savings accounts
Even the “savings account” half of TFSA is misleading.
Since only investment gains are tax-exempt, treating your TFSA like a conventional savings account - which normally generates negative returns after fees - is pointless.
Even returns on “high-interest savings accounts” are paltry for small amounts and well below two per cent for high balances.
TFSA contributions need to be invested to benefit from tax savings. That could include guaranteed investment certificates (GICs), which currently yield about five per cent annually and would otherwise be fully taxed in a non-registered account.
Tax-effective TFSA investments also include equities 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), which permits contributions to be deducted from your taxable income.
Returns on TFSA investments are generally tax-exempt but contributions are not.
4. You can recontribute at any time
Unlike the RRSP, TFSA withdrawals can be made at any time without tax consequences.
Also unlike the RRSP, the allowable contribution space from a TFSA withdrawal is fully restored.
But if you contribute the maximum amount, the contribution space from a TFSA will not be restored until the following calendar year.
5. The bank will inform you when you’re maxed out
Many Canadians contribute to their TFSAs through more than one institution and it is the account holder’s responsibility to ensure they don’t exceed their limits. Over-contributions could result in financial penalties.
The CRA keeps track of TFSA limits for individuals on their annual tax statements and CRA online accounts but they are usually for the previous year, so be sure to include contributions made in the current year.
The total TFSA contribution limit for anyone over 18 years old was expanded by $7,000 starting Jan. 1. Accumulated contribution space varies for individuals based on contributions and withdrawals made over the years.
To get an idea of its potential significance, the total allowable amount for those 18 years or older since inception is now $95,000.
6. TFSAs are for short-term goals
The TFSA is generally seen as a short-term savings tool to finance things like a new car, a pool or that big vacation. That’s true, but considering how much the contribution limit has grown, it can also be a tax-efficient retirement savings tool to work in conjunction with an RRSP.
RRSP contributions and any gains they generate as investments are fully taxed when they are withdrawn. If those investments grow too much, retirees could be forced to make withdrawals in a higher tax bracket and even face Old Age Security (OAS) clawbacks.
Strategically splitting retirement savings between an RRSP and TFSA today allows you to limit RRSP withdrawals to the lowest tax bracket in the future, and top up required funds with non-taxable TFSA withdrawals.