I recall a teacher in high-school constantly made reference to the KISS principle. Keep It Simple Stupid. Having that mentality in mind, I am going to apply that concept and take a closer look to the often misunderstood and underutilized tax-free savings account (TFSA).

Introduced in 2009, the TFSA was brought to the table for Canadian residents who are 18 years of age or older and who have a valid SIN. However, to this day there are many who do not completely understand the advantages of this account type, nor take full advantage of the account.

The Name

First off, the name. A tax-free savings account immediately presents itself as a savings account. A more applicable name for this account would be a tax-free investment account. The main advantage of the TFSA is that when growth or income is earned, (such as interest, dividends, and capital gains), it is realized on a tax-free basis and is not taxed by the government the year it is earned or when monies are withdrawn.

The TFSA is truly taken advantage of when qualified investments are held within the account, income and/or growth is realized, all tax free. Investments such as the following can be held within a TFSA:

Individual stocks

Mutual funds

ETFs

Bonds

GICs

After-tax Monies

Contributions into a TFSA are after-tax monies, unlike a RRSP. Let's run through a simple example to illustrate the benefit. Assume income earned through employment is $100, with a tax rate of 30%.

As cited above, contributions to a TFSA are made with after-tax money. Therefore the individual would be able to contribute $70 ($100 * (1 – 30%)), which is the amount of money available after-tax. This contribution could be invested into a qualified investment and if the investment grows to $85 over time, the $85 ($70 principle and $15 growth) could be withdrawn from the account and no taxes would be paid.

Contributions

Contribution room is accrued beginning January 1, 2009 and unused contribution room is carried forward indefinitely. Since 2009, the contribution room of the TFSA accumulates every January. As of January 1, 2018, the contribution limit for a TFSA is $57,500. Instead of contributing cash to a TFSA, in-kind constitutions can also be made. For example, if you have contribution room of $10,000 and own a qualified investment in a non-registered account with a market value of $10,000 or less, it can be moved in-kind. Do note that capital gains will be triggered and included in income if the qualified investment is trading above book value. On the contrary, if the qualified investment is trading at a loss and contributed in-kind to a TFSA, the capital loss will be denied. Therefore attention to detail should be taken especially when contributing in-kind securities to a TFSA.

Withdrawals

Withdrawals can be made at any time during the year. Withdrawals that are made during the year will be added to your contribution room for the following year.

As an example, assume Lisa opened a TFSA and contributed $57,500 in January 2018. In May 2018, $5,000 was withdrawn from the account. The earliest that Lisa will be able to re-contribute the $5,000 withdrawal is January 2019.

Estate Planning

Since the TFSA is a registered account, there can be named beneficiaries on the account.

When a spouse or common-law partner is a Beneficiary

The surviving spouse or common-law partner will be able to transfer the deceased's TFSA at the value on date of death to his or her TFSA. Contribution room is not needed to complete this contribution.

When a Beneficiary is an individual other than spouse or common-law partner

The value of the TFSA on date of death will be paid to the beneficiary or beneficiaries. The account will transfer to the beneficiaries outside the estate and avoid probate fees.

Summary

A tax-free savings account should be thought of as a tax-free investment account, which is truly taken advantage of when investments held within the account realize tax-free growth and income.

Be careful not to over contribute, as there will be penalties imposed by CRA.

When contributing assets in-kind, be sure to take note as to whether the asset is trading at a gain or loss.

Being a registered account, the TFSA can have named beneficiaries.

Sources

Canada Revenue Agency