Advantages of a TFSA: What you should know

Despite its name, did you know that a Tax-Free Savings Account (TFSA) is more than just a savings account?

That’s right. It offers much more than that.

Because of its many attractive investment options, people might say it is more like a tax-free investment account.

TFSAs can hold complex products – such as securities like certain mutual funds, exchange-traded funds and equities – that go above and beyond your usual savings account.

Plus, all TFSA investment earnings are generally tax-free. One of the many advantages of a TFSA is the bonus of providing tax-free withdrawals as well. In comparison, in a Registered Retirement Savings Accounts (RRSP), investment earnings are tax-deferred and withdrawals are taxable

In case you are wondering, yes, you did read that correctly: in general, you do not pay taxes on TFSA earnings or withdrawals.

Let’s explore how TFSAs work, why they’re useful, and how they differ from other savings and investment accounts.

How does a TFSA work?

One of the primary advantages of a TFSA is the ability to withdraw funds at any time without penalty. However, there are restrictions as to how much you can contribute annually.

Each year, the Canadian government determines the maximum amount that a holder of a TFSA can contribute (that amount is now $7,000 for 2024, by the way). Any resident of Canada who turns 18 years old on any date within a calendar year becomes eligible to make contributions. 

At that time, the TFSA holder’s “contribution room” begins to accumulate. This is the difference between the aggregate maximum deposit allowed and the actual amount contributed. If you do not meet your contribution limit each year, that difference is rolled into the next year and added to the contribution room.

These roll-overs are allowed every year up to and including the lifetime contribution limit, which is $95,000 for 2024.

Six important advantages of a TFSA 

A TFSA can be an attractive investment option for several reasons. While there are multiple benefits to consider, there are six important advantages of a TFSA that you should understand.

Your contributions and withdrawals are tax-free.

As stated previously, any investment income earned within your TFSA is generally tax-free. This includes ordinary interest, dividends on equity investments, capital gains and other investment income. These tax benefits are unlimited, meaning that even as the investment return on your assets increase, taxes, in general, will never kick in.

It is also worth repeating that you can take money out of your TFSA for any reason, in any amount, and at any time, without paying taxes.

This flexibility makes TFSAs ideal for those once-in-a-lifetime (or at least infrequent) purchases that can make you really stretch your pockets. 

There are no mandatory withdrawals.

While these instruments are ideal for your big-ticket items, they are also a great way to invest for the long haul. You may have opened a TFSA after having already purchased your home or a new car, and now you are looking for a long-term investment vehicle. Without any anticipated large expenditures on the horizon, you may have the advantage of letting your money grow.

If that is the case, TFSAs include no mandatory withdrawals (and your investments can continue to grow tax-free) throughout your entire lifetime.

Your withdrawals do not affect government benefits.

Another important (but often less talked about) perk is that withdrawals from a TFSA are not considered income. While this is certainly significant from a tax perspective, it also means a TFSA’s performance will not affect most income-tested government benefits you may receive.

This is not necessarily a selling point for every investor, but might be a lifesaver for low-income seniors who receive benefits with harsh claw-back terms. 

You and your spouse/common law partner can pool contributions.

You make TFSA contributions with after-tax dollars. The Canadian Revenue Agency (CRA) allows contributions to a spouse’s or common-law partner’s TFSA. You are permitted to contribute to your spouse/common-law partner’s TFSA (and vice versa) to maximize your contributions.

Earned income is not a factor.

Unlike many other investment accounts, a TFSA does not require you to earn an income to contribute. 

This can prove particularly useful for university students, retirees who do not work or some one who is currently unemployed and comes into a lump sum of cash, but otherwise does not receive a regular paycheque.

An efficient tax strategy for estate planning

This is not a topic that anyone likes to discuss, but it can be important when looking to secure your loved ones’ financial futures.

Payments out of a TFSA can be made to a beneficiary – be it a family member or friend – with no tax implications upon the original account owner’s death, subject to certain limitations. This process will be discussed in more detail later in the article.

Three common investment types (beyond cash)

One of many advantages of a TFSA is investment flexibility. A TFSA portfolio can comprise multiple investment types. Three common products are as follows.

Mutual funds

Mutual funds are a portfolio of pooled equities, commodities and bonds, and are actively managed by a portfolio manager. Mutual funds tend to be a mixed bag of varying industry and sector types, and the level of risk and potential return varies by fund. The more diverse your portfolio, the less you are exposed to any single investment strategy.

There are many mutual funds from which to choose, depending on your specific risk appetite.

Exchange-traded funds

An exchange-traded fund (ETF) is an investment product similar to a mutual fund, in that it consists of a portfolio of different asset types and classes.

However, unlike a mutual fund, most ETFs track a predetermined index. Individual investors may purchase units of an ETF to be held in their TFSA directly on a designated stock exchange, whereas units of a mutual fund are purchased through a broker or financial advisor. 

Listed equities

Listed equities have the potential to earn a return on an investment. However, the potential higher reward comes hand in hand with a higher risk. Typically, investors in equities are savvier investors with relatively advanced financial knowledge and investment experience. They also tend to have more disposable income at hand and can afford a higher risk appetite. 

It cannot be stressed enough that a TFSA is an investment vehicle that allows you to purchase investments such as mutual funds, ETFs and equities. Unlike a traditional savings account, your TFSA options are much more robust.

Who is eligible?

Every resident of Canada who is 18 years of age or older and possesses a social insurance number is eligible. 

What happens if you become resident of another country?

If you become the resident of another country after opening your TFSA, you are not required to close the account. Rather, you can leave it open, and you will not be taxed in Canada on any earnings or withdrawals.

You are not permitted to contribute to your TFSA in any year in which you are a non-resident for the entire calendar year. You can, however, contribute as a non-resident during the year in which you switched residencies. You should be aware that you will be charged a one percent tax penalty for each month that a disallowed non-resident contribution remains in the TFSA. 

No TFSA contribution room will accumulate for any year throughout which you are a not a Canadian resident. Any withdrawals made during the period that you were a non-resident will be added back to your TFSA contribution room in the following year. However, you will only have access to this contribution room if you re-establish your Canadian residency.

You can contribute to a TFSA until you become a non-resident of Canada. The annual TFSA dollar limit is not pro-rated in the year you leave or the year you come back.

What are the differences between a TFSA and RRSP?

TFSAs and RRSPs are both investment vehicles with attractive tax advantages that can help map out your financial future. These two accounts have several differences, and it’s important to understand the benefits of each before making an investment decision.

A TFSA is an investment account that can be used dynamically. As your life and financial objectives change, your TFSA can adapt accordingly to optimize your goals.

One of the major advantages of a TFSA is that you can make withdrawals as you see fit, with no penalty. You are also free to reinvest those withdrawals in a later year.

All eligible investors are restricted to the same annual contribution amount: it is not determined by your income.

An RRSP, on the other hand, is an investing account meant to provide you with income at retirement. Unlike a TFSA, your annual contribution limit is determined by your prior year’s income, subject to a maximum annual limit.

Tax treatment

Contributions to your TFSA are not tax deductible, while contributions to your RRSP are tax deductible. In other words, any contributions you make to a RRSP may reduce your personal income tax liability. 

However, earnings and growth within both a TFSA and an RRSP are not taxed.
TFSA withdrawals are generally tax-free; however, ordinary withdrawals from RRSPs are subject to income taxes at ordinary rates.

Withdrawal amounts

If you withdraw funds from your RRSP, you cannot recoup that lost contribution room. However, there are exceptions for withdrawals, such as the Home Buyer’s Plan (HBP) and the Lifelong Learning Plan (LLP). Withdrawals from a TFSA, however, are credited to you in the following calendar year. 

Contribution requirements

The TFSA contribution limit for 2023 is $6,500. Meanwhile, the contribution limit for an RRSP is the lesser of either 18 percent of your earned income in 2023 or $30,780.
While the contribution limit for a RRSP is potentially higher than that of a TFSA, you can only contribute to an RRSP if you have earned income. 

Maximum maturity

Your RRSP will mature at the end of the calendar year in which you turn 71. Typically, an RRSP is matured into a Registered Retirement Income Fund (RRIF), and you must start withdrawing funds in the following calendar year. 

A TFSA, on the other hand, has no required maturity date. 

There are no restrictions on use.

Funds withdrawn from a TFSA have no restrictions, meaning that there are no penalties associated with how you use the money. 

While your options are practically limitless, five potential uses are as follows.

Saving before and after retirement

TFSAs are becoming an increasingly popular means of retirement planning for younger investors (40 and under) who hope to retire early. If that is your plan, you may not yet be eligible for employer pensions at your time of retirement, or ready to begin drawing from you RRSP account. In this situation (and depending on other circumstances), a TFSA may serve as a bridge until you begin receiving pension income or making withdrawals from your RRSP.

Also, just because you are no longer saving for retirement does not mean you should not save during retirement. Many retirees can continue to contribute to savings post-employment, but if you are not working, you are not generating RRSP contribution room, and are unlikely to be able to contribute to an RRSP.

At the end of the calendar year in which you turn 71, you are required to mature your RRSP. Most people convert their RRSP into a Registered Retirement Income Fund (RRIF). This does not mean that you have to stop saving after you reach the age on 71. 

When you retire, it is possible that your expenses will be less than the cash flows received from a RRIF, certain government-sponsored plans (such as a CPP or OAS) or other retirement income sources. If that is the case, you may consider contributing that unused cash to your TFSA.

As already discussed, you can continue contributing to a TFSA indefinitely.

Your children’s education

A TFSA can be an excellent investing option for a child’s future education. This is particularly true if you have already taken full advantage of the maximum grants available through a registered education savings plan (RESP). 

If you have maxed out your own contributions each year, you can provide your children with money to open their own TFSAs, provided they are 18 years old. 
However, always remember that there are no required uses for TFSA funds. If your child does not attend a university, or the money turns out not to be needed for that purpose, there is no penalty for doing something else with the money.

You should also keep in mind that you do not need to rely on your children’s TFSAs to finance their education. You can set aside funds from your own TFSA to help pay for their (or even your grandchildren’s) education.

Emergencies can happen at any time.

TFSAs can make great rainy-day funds, because you can draw any amount of money at any time you choose. You might have an unexpected expense, such as a new car purchase or major house repair that you need to cover. Or a downturn in the economy might result in an unforeseen job loss. 

Life can throw you for a loop at any time – it happens to the best of us. When that happens, having a TFSA to lean on could be crucial to staying afloat until you get back on your feet.

Health care for aging parents

Many young and middle-aged adults find themselves caring for their elderly parents. This can often require not only your compassion, love, and time but additional money as well. Your parents might require an at-home care professional or a long-term retirement home. If that is the case, a TFSA can provide means to pay for these significant expenses. 

Keep in mind that you can also provide your parents with money to invest in their TFSAs if you have maximized your own contributions.

Collateral for a loan

This is not necessarily as common a use of TFSAs, but they can be used to help secure a loan. 

If you are anticipating a large expenditure that requires a loan – such as the purchase of a new house or car – a TFSA can be provided as collateral. This may become a desirable option when your underlying credit score alone is not sufficient to receive loan approval and you own limited assets.

This is another feature that’s generally unavailable for RRSPs. Many institutions are prohibited from acquiring assets held in an RRSP, and accordingly they generally cannot be posted as collateral.

Please note, however, that while the underlying TFSA assets are designated as collateral, you typically cannot make any withdrawals from the account.

Tax advantages of a TFSA: A closer look

While the tax-free earnings inside a TFSA and withdrawals from a TFSA tend to be its greatest selling points, you should understand that these accounts are not immune to tax penalties. There are a few specific (and generally uncommon) situations under which taxes might apply.

First, while the government imposes a limit on annual contributions, you should note that you can unintentionally over-contribute to your TFSA in any given calendar year. There is no mechanism to automatically prevent you from accidentally over-contributing to your TFSA.

Any contributions left in the account that exceed the current contribution room will be subject to a 1% penalty tax. This tax will be assessed monthly for every month that this excess amount is left in the TFSA. 

For example, if you contribute an extra $1,000 in January and leave it there until year-end, you will pay $120 (or $10 x 12) in penalties, plus interest. In a nutshell, it’s advisable to monitor your account and stick to your unused TFSA contribution room, which can be found by logging into “My Account” through the Canada Revenue Agency website.

Second, and noted previously, if you are a resident of another country for the entire year and you contribute to your TFSA, you will be subject to the same monthly tax of 1% for contributions made while abroad.

Contribution rules: A closer look

As already discussed, the maximum annual contribution you can make in 2024 to a TFSA is $7,000. That amount is cumulative, and any unused contribution amounts are rolled into the following year. 

Another advantage of a TFSA that has not been discussed in detail is that the rolling contribution room is not affected by the account’s performance. In other words, as your TFSA’s value increases due to a healthy growth of investments and related income, the contribution room is not reduced. 

If you have yet to open a TFSA and were at least 18 years old when the TFSA was introduced in 2009, you could have eligible contribution room of $95,000 (as of 2024).

Beneficiary rules

As briefly discussed earlier, one of the important tax advantages of a TFSA is the possibility to transfer an account to a beneficiary upon the original owner’s death. Four important considerations are as follows. (Please note, however, that Quebec only allows transfers to be done via the estate.)

Tax treatment 

When the owner of a TFSA dies, the market value of the account at the time of death is recognized as the tax-free amount to be “received” by the TFSA owner. This is the lump sum that will be transferred to the account’s beneficiary tax-free and with no other associated penalties.

It is important to note and understand that the relationship status of the beneficiary (e.g.,  a spouse, compared with another family member, compared with a non-relative) has no impact on the account’s tax treatment upon the death of the original owner. However, any investment growth after the original owner’s death might be subject to taxation, depending on the nature of that relationship.

The “successor holder” and “beneficiaries”

An eligible successor holder is either a surviving spouse or common-law partner designated as a successor holder in the TFSA contract or in the deceased holder’s will. Other family members do not qualify as successor holders. All rights under the agreement are transferred immediately, and the successor holder’s position supersedes those of any other designated beneficiaries. 

The TFSA will only continue to earn tax-free returns and provide tax-free withdrawals if the spouse or common-law partner takes ownership as a successor holder.

Spouse/common-law partner designation

If you designate your spouse or common-law partner as a beneficiary, as opposed to a successor holder, alternative contribution and tax rules apply. Spouses or common-law partners will have until December 31 of the year following your death to contribute funds received from your TFSA to their own account without affecting their own unused TFSA contribution room. Survivors must designate their survivor payment as an exempt contribution on Form RC240 and send the designation within 30 days after the contribution is made, or at a later date as permitted.

Keep in mind that only the account’s value at the time of death can be transferred without an impact on the beneficiary’s contribution room.

More specifically, in the absence of another designated beneficiary, the TFSA will pass to your estate. If your will does not specify otherwise (or if you did not prepare a will in the first place), your spouse or common-law partner will likely inherit any unclaimed remainder of your estate by default. This would include your TFSA.

Other beneficiary

If you appoint a beneficiary who is not your spouse or common-law partner, any positive gains on the TFSA after the date of death will be treated as income and taxed as such. Similarly, if the TFSA is assigned to your estate because you did not designate a beneficiary, post-death income will be subject to taxation. 

Estate planning

If you are approaching retirement or in retirement and have available TFSA contribution room, you may consider contributing to your TFSA for estate planning purposes. Upon death there are no taxes on TFSA deemed disposition. However, there are taxes on RRSPs or RRIFs that are deemed to be disposed on death and not rolled over to a surviving spouse. 

Can you move a TFSA between financial institutions?

Yes, you can transfer your TFSA to another financial institution, although fees may apply. 

Some institutions will reimburse you for any fees associated with a transfer to one of their accounts, so you should be sure to review each financial institution’s policies. Otherwise, transferring a TFSA typically has no financial impact on the account.

How to open a TFSA

The process is streamlined and simple. Canadian residents who are at least the age of majority in their province or territory of residence (18 years old or 19 years old, depending on the province or territory) and have a valid social insurance number can open a TFSA account. Please note that regardless of the age of majority in your province or territory, you still earn contribution room at 18, but can not administratively open the account until you are 19 years old, in certain provinces or territories.

A financial advisor can be a great starting point for opening a TFSA account. Your financial advisor can create a plan on how a TFSA can help you achieve your financial goals. This provides you with access to knowledgeable advisors who can help you chose your investment products for each goal.

You will then need to provide them with your social insurance number, date of birth (and a piece of identification) and other supporting documentation that may differ by institution. 

Do not wait: Open a TFSA today

If you are eligible and have the means, you should strongly consider opening a TFSA. The process is quick and easy, and the sooner you invest, the sooner you can start realizing tax-free earnings. 

Remember, while there is a maximum amount you can contribute each year, there is no minimum amount. Even small contributions can help you realize long-term growth for retirement, help prepare you for shorter-term expenses or provide a safety net during an emergency. As has been discussed, the uses of TFSA funds are nearly limitless.

While investment flexibility is one of the main advantages of a TFSA, choosing how to invest in that account might be a difficult decision. No two investors are the same, and an investment plan that works well for a friend or family member may not work for you. 

At Fidelity, we understand that clients have their own objectives, and each one requires a specific investment plan. A TFSA is more than a savings account, it’s an investment account.

Talk to your advisor about using Fidelity mutual funds and ETFs in your TFSA.