A TFSA, or Tax Free Savings Account, is a type of savings account able to hold a wide variety of investments. The primary benefit of a TFSA account is that any income generated by the assets within the TFSA grow tax free. That is, if you put $100 into the account, and it grew to $200 you wouldn’t have to pay any taxes on this growth.
One of the most often confused parts of a TFSA, is that it isn’t actually an investment itself. I often hear people talk about how they have invested in a TFSA and are confused when I ask what it is invested in. A TFSA is not simply a savings account where you are paid a small interest rate on the value of money within it. You can however hold a high interest savings investment vehicle inside a TFSA and this is a very common option at the bank and is the reason for the common misconception.
I like to explain to people that you need to view an account, like a TFSA, as a way to hold something. The best example I give is look at it as a type of cup. The cup, is the account type, and the investments are the liquids that are inside the cup, and the taxes are what happens when the volume of liquid changes in the cup. Now there are lots of types of cups or accounts, TFSA’s, RRSP’s, RESP’s, RRIF’s, LIRA’s etc etc. The beauty is that you can hold the same type of investments, or liquids inside any of the types of cups or accounts. The type of account simply impacts the taxation of the account.
You see, inside a TFSA you can hold many different types of investments. Stocks, Bonds, ETF’s, Hedge Funds, Mutual Funds, GIC’s, High Interest Savings accounts, Cash, you name it and you can probably hold it in a TFSA.
The beauty of a TFSA, is that when you do hold an investment like a Stock inside a TFSA there are no tax complications. Hence the name, Tax Free. When you put money in, no tax benefits. When money grows within, no tax payable. When you take money out, no tax payable.
The main caveat to the TFSA is there is a contribution limit. You can only put so much into the account. This amount increases every year after the year in which you turn 18, and it increases by any amount you withdraw from a TFSA.
I know that last bit is confusing, so I’ll give you another example.
If your TFSA contribution limit is $69,500 (the current 2020 limit), and you contribute $69,500 to the TFSA then you are out of TFSA contribution room. Now, the good news is it doesn’t matter how much that account grows to. So if it grows from $69,500 to $76,000, you have not gone over your limit. The limit is based on how much you deposit to the account, not how much it has grown by. Now if you were to withdraw that $6,500 in growth, your limit would actually increase by the amount of the withdrawal. Now this increase doesn’t happen immediately. It happens on January 1’st of the next year when you get your annual contribution limit increase as well.
When January 1’st comes around, your limit will increase by the new limit of $5500, plus the amount of your withdrawals in the past year of $6500. Bringing your new limit to $69,500 + $5,500 + $6,500.
Another common question I get about TFSA’s is that you can have any number of TFSA accounts that you want. You can have 3 with your bank, 2 with your financial advisor and 140 with your online broker if you want to. The contribution limit applies to the total of all of your accounts, so as long as the cumulative total you contribute to all of your TFSA’s stays under the limit, then you can have as many accounts open as you would like.