Who should invest in a TFSA?
- New investors: TFSAs stimulate greater long-term savings when you start earlier.
- Seniors: Neither withdrawals nor income earned in a TFSA will trigger clawbacks on Old Age Security benefits or the Guaranteed Income Supplement.
- High income earners: Taxpayers who are in high tax brackets and have already maxed out their RRSP can use a TFSA to shelter more of their income.
- Lower income earners: Instead of the modest tax deduction of an RRSP, taxpayers in a lower tax bracket may prefer the tax-free growth and withdrawals of a TFSA.
- Anyone saving for a large ticket item: TFSAs can be used to fund a car purchase, vacation or down payment for a house.
It is generally a good idea to maximize both an RRSP and TFSA. The invested money would benefit from tax-efficient growth, which generally leads to enhanced portfolios in the future. A TFSA growth calculator can illustrate the type of growth you may generate when you invest in a TFSA. Go online to find a TFSA calculator today.
No one solution suits everyone. Here are some ways you can determine what plan works best for you:
- Are you investing for the short-term or long-term? If you are investing for the short-term (ex. saving for a car, vacation, etc.), a TFSA is generally considered the better option. Withdrawals from a TFSA are tax-free and you may re-contribute that withdrawal in a later year. RRSPs are generally used for long-term needs or specific short-term needs where special access is provided, such as the Home Buyers’ Plan or Lifelong Learning Plan. Use a TFSA vs. RRSP calculator to see what type of growth you can expect with each plan.
- What is your current and expected tax rate? Your tax rate at the time of contribution and withdrawal matter. For example, if you are currently taxed at a 45% tax rate and intend to withdraw your RRSP or TFSA while still at a 45% rate, the after-tax amount from each plan would be the same, assuming the rates of return are identical. When your tax rate at the time of contribution exceeds your tax rate at the time of withdrawal, RRSPs produce greater after-tax amount. On the other hand, where your tax rate at the time of contribution is lower than your tax rate at the time of withdrawal, TFSAs provide the greater benefit.
- Income-sensitive benefits. You are less likely to receive benefits such as Old Age Security (OAS), Guaranteed Income Supplement (GIS), Canada Child Tax Benefit (CCTB) and the Age Credit as your taxable income grows. This reduction of benefits can be considered an added tax for those subject to them. While RRSP and RRIF withdrawals are income that can reduce federally sponsored income-sensitive benefits, TFSA withdrawals do not. If you believe your future income may hover near clawback thresholds when you withdraw your funds, it may be better to pull from a TFSA.
Can’t contribute to an RRSP?
There are many reasons why Canadians cannot contribute to an RRSP, such as an insufficient amount of earned income, contributions to an employer pension plan or reaching the age of 71, which is when RRSPs must be converted to RRIFs. TFSAs are an ideal solution for those who have maximized their RRSPs and want additional tax-saving opportunities. Regardless of your employment status, age (other than a requirement to be at least 18), or contributions to employment pension plans or RRSPs, Canadians have $5,500 of TFSA contribution room each year, subject to inflation. Use a TFSA growth calculator to calculate what growth you could expect by investing in a TFSA.
The Versatility of TFSAs
Meg is a 50-year-old mother of two. While she earns enough to put money aside each year, she is reluctant to lock up her investments for the long term because she wants cash available for unpredictable expenses like home and vehicle repairs. Meg also wants market exposure and a higher rate of return.
RRSPs are best for long-term investing, so Meg is considering a TFSA (non-taxable investing) versus non-registered investing (taxable investing). The TFSA is the best option for Meg because TFSAs can encompass a variety of investments and investment income in a TFSA is tax-free. As the value of her TFSA increases, Meg can use some of those funds to make contributions to her RRSP.
Jimmy, 23, is a new graduate who recently joined the workforce. Like many new graduates, he is currently in the lowest tax bracket. Jimmy still lives with his parents, has low expenses and the money to invest.
Jimmy could use an RRSP for his long-term investments to defer tax on a portion of his employment income; but if he thinks he may require the assets when he is in a higher tax bracket, the TFSA might be a better fit. His contributions would not generate a tax deduction, but future withdrawals, including income and capital gains earned, would be tax-free – unlike a RRSP. A withdrawal from an RRSP would be taxed at the higher tax bracket at the time of withdrawal.
Alex is a business owner who maximizes his RRSP each year to shelter as much of his income from tax as possible. The problem is, other than the RRSP, there are very few tax shelters available in Canada.
Alex could use the TFSA as a complement to his RRSP. He is in the highest tax bracket, so the tax deductions achieved by his annual RRSP contributions would likely continue to be of value. Once he has reached his RRSP contribution limit, excess funds could be invested in a TFSA for additional tax-saving opportunities. He could fund additional TFSA contributions from the tax refund generated from his RRSP contributions.
Allen is a 72-year-old RRIF annuitant who will begin to receive RRIF payments by the end of the year. Allen does not require the extra cash, as his annual expenses are minimal and he is adequately provided for by Old Age Security (OAS), Canada Pension Plan (CPP) and pension income. Allen would like to continue to invest the money received from his RRIF, but is concerned that additional investment income could result in a clawback of income-sensitive OAS benefits.
Allen could use a TFSA to reinvest the cash from his RRIF. Unlike RRSPs, there is no maximum age restriction for TFSA contributions, so seniors can benefit from the plan the same as any other investor. In addition, future investment income will grow tax-free in the TFSA, as opposed to being tax-deferred in the RRIF. Should Allen require cash from his TFSA, withdrawals can be made without affecting his OAS benefits.
TFSAs are tax-free accounts. As a result, taxes are typically not a concern when you transfer assets from a TFSA to other savings plans, like an investment account, RRSP, RRIF or RESP. The transferred amount is considered a withdrawal and subject to TFSA withdrawal rules.
If someone owns multiple TFSAs and transfers funds between them, this is known as a “qualifying transfer.” In this case, contribution room is not affected – you will neither gain nor lose contribution room for the amount transferred. A qualifying transfer also occurs if you transfer TFSA assets to a former spouse or common-law partner because the end of a relationship; however, the contribution room to your TFSA is not restored. Your former spouse or common-law partner does not require room to receive the transfer, which requires a formal divorce decree or separation agreement.
If other savings plans, such as investment accounts, RRSPs, RRIFs and RESPs are transferred to your TFSA, the transferred amount would normally be taxable in the year of the transfer and would require TFSA contribution room. When it comes to investment accounts, capital gains tax is generally payable when it is transferred to a TFSA for assets that have gone up in value. Assets that have gone down in value are treated differently. Because of specific rules in the Income Tax Act, your capital losses will be denied if you transfer depreciated assets directly to your TFSA.
When you set up a TFSA, you can name a “successor holder” to continue holding your plan upon your death. The Income Tax Act restricts the naming of a successor holder to your spouse or common-law partner. TFSA over-contributions that exist at the time of your death will be deemed contributions made by your successor in the month following your death. If your successor has sufficient TFSA contribution room to absorb the over-contributions, over-contribution penalties will cease.
When a successor holder is not named, but your spouse or common-law partner inherits your TFSA, he or she can transfer those assets to their TFSA, as long as the transfer occurs during the “rollover period,” which begins on the date of death and ends on December 31st of the following year. Transfers that occur during the rollover period are defined as an “exempt contribution” and do not require TFSA contribution room. This will allow for continued tax sheltering.
Exempt contributions are generally limited to the fair market value of the transferring TFSA at the time of death. TFSA growth after death would require new contribution room. To ensure exempt contributions do not affect the contribution room of a receiving spouse or common-law partner, the contribution must be designated on CRA form RC240, Designation of an Exempt Contribution Tax-Free Savings Account (TFSA), which must be sent to the CRA within 30 days of contribution.
Individuals other than spouses and common-law partners can inherit TFSAs, but cannot make exempt contributions. While TFSA assets can be transferred to these beneficiaries tax-free (for amounts up to the date of death), TFSA contribution room is required to shelter future income from tax.
In the absence of a successor holder, income earned in a TFSA after the date of death is subject to tax – a tax normally payable by the recipient of the TFSA. This is the case regardless of whether or not a spouse or common-law partner is beneficiary.
Federal legislation does not specify whether a beneficiary can be named directly on a TFSA application or not. An application designation can help reduce estate administration fees and avoid complex estate settlements. This is not unusual, as the transfer of assets at death is governed by provincial and territorial legislation. In order to transfer TFSAs to beneficiaries through a plan application, as opposed to a transfer by way of will, there must be provincial or territorial legislation that allows for it.
All provinces and territories, other than Quebec, have updated legislations to allow for beneficiary designations on TFSA applications. In Quebec, TFSA transfers at death continue to pass through the deceased’s estate and are governed by the deceased’s will. Designations continue to be of importance in Quebec, as a result.
The TFSA is designed to complement, not compete with, existing savings plans. The RRSP, RRIF, RESP, Registered Pension Plan and Registered Disability Savings Plan each play a role in investment planning and are designed to satisfy a specific objective. TFSAs bridge the gap between registered and non-registered investing by offering the tax-efficiency of registered accounts and the flexibility of non-registered investments. Speak to a financial advisor to determine the best way to maximize a TFSA.